Composite habits and international transmission of business cycles

Abstract

This paper shows how internal habit formation defined over a composite of consumption and leisure can bring a two-country business cycle model closer to the data. Conditional on productivity shocks, our model reconciles with the data by closing the gap between cross-country correlations of consumption and output. It also predicts positive international correlations of investment and employment of the magnitude observed in the data. In other words, a rather parsimonious departure from a canonical two-country, two-good model goes a long way toward addressing two long-standing puzzles: the “quantity anomaly” and the “international comovement puzzle”.