Explaining International Business Cycle Synchronization: Recursive Preferences and the Terms of Trade Channel
28 Pages Posted: 22 Mar 2017
Date Written: March 20, 2017
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.
Keywords: international business cycle synchronization, recursive preferences, terms of trade, real exchange rate, wealth effect on labor supply
JEL Classification: F31, F32, F36, F41, F43
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