DP11911 | Explaining International Business Cycle Synchronization: Recursive Preferences and the Terms of Trade Channel

Author(s)

Publication Date

03/17/2017

JEL Code(s)

Keyword(s)

Programme Area(s)

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 comove positively.