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Do open economy models with credit constraints resolve the output correlation puzzle? Building on Deverex & Yetman (2009), the authors develop a two good open economy model with international credit constraints that features both strong cross-border trade as well as - financial linkages. They show how endogenous movements in the terms of trade and labour supply allow their model to match the observed cross-country output correlations. Increasing the amount of cross-border asset holdings increases international business cycle synchronization. This model - with its strong trade linkages - is particular suited to understanding the 2007-2010 economic crisis including the 2008 world trade collapse.
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