Abstract
We characterize an international production economy in which (1) agents have Epstein and Zin (1989) preferences, (2) international productivity frontiers are exposed to both short- and long-run shocks, and (3) consumption features a larger degree of home bias relative to investment. Under our recursive risk-sharing scheme, good long-run news for domestic productivity creates a net outflow of domestic investments. This response accounts for the Backus, Kehoe and Kydland (1994) anomaly concerning the lower degree of correlation of international consumption relative to output. We document that our model is strongly consistent with novel empirical evidence on both international quantities and prices.
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