Working Paper

Explaining International Business Cycle Synchronization: Recursive Preferences and the Terms of Trade Channel

Abstract: The business cycles of advanced economies are synchronized. Standard macro models fail to explain that fact. This paper presents a simple model of a two-country, two-traded good, complete-financial-markets world in which country-specific productivity shocks generate business cycles that are highly correlated internationally. The model assumes recursive intertemporal preferences (Epstein-Zin-Weil), and a muted response of labor hours to household wealth changes (due to Greenwood-Hercowitz-Huffman period utility and demand-determined employment under rigid wages). Recursive intertemporal preferences magnify the terms of trade response to country-specific shocks. Hence, a productivity (and GDP) increase in a given country triggers a strong improvement of the foreign country?s terms of trade, which raises foreign labor demand. With a muted labor wealth effect, foreign labor and GDP rise, i.e. domestic and foreign real activity commove positively.

JEL Classification: F31; F32; F36; F41; F43;

https://doi.org/10.24149/gwp307

Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2017-03-01

Number: 307

Pages: 26 pages