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

Author(s): Robert Kollmann
Publication Date: March 2017
Keyword(s): international business cycle synchronization, real exchange rate, recursive preferences, terms of trade, wealth effect on labor supply
JEL(s): F31, F32, F36, F41, F43
Programme Areas: International Macroeconomics and Finance
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11911

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.