International Real Business Cycle Model Research Articles

Aggregate Properties of Open Economy Models with Expanding Varieties

Abstract We present a unified framework to study interconnections between business cycle and international trade models. This unified framework is built upon the standard competitive, representative-firm international real business cycle model and features production externalities in the intermediate and final goods sectors. Our main theoretical result is that this unified framework is equivalent in aggregate implications to dynamic international trade models featuring monopolistic competition, endogenous entry and exit, and heterogeneous firms. We show that a negative capital externality in the intermediate good sector is required to fit the data. This presents a puzzle for the literature because when viewed through the lens of our unified framework, we demonstrate that the standard assumptions used in dynamic trade models imply a positive capital externality.

The international real business cycle when demand matters

This study explores the demand side of an international real business cycle model adopting additive intratemporal preferences over differentiated final goods and monopolistic competition. It shows that the structure of the demand system matters for macroeconomic dynamics by affecting firms’ pricing over time and across countries. The endogenous variability of markups and profits amplifies the propagation of shocks through novel substitution effects, generating positive comovements of output, labor and investment, and reducing consumption correlation between countries. In particular, a positive shock in the Home country improves its terms of trade, promotes consumption in the Home country and also production in the Foreign country.

Asymmetric trade liberalizations and current account dynamics

AbstractI propose asymmetric trade liberalizations as a new potential determinant of current account dynamics. I focus on South Korea, which experienced a rise and fall of its current account in the period from 2010 to 2018, when it signed preferential trade agreements (PTAs) with its main trading partners. First, I develop a model where the current account depends on the timing of present and future relative changes of trade costs. Second, I provide empirical evidence supporting the key predictions of the model using the Canada–Korea PTA. PTAs provide predictable, potentially asymmetric, future tariff paths on many products. I use information for over 2,500 HS‐6 products to build relative trade liberalization measures, and show that current (future) high relative trade liberalizations tend to decrease (increase) the trade balance, consistent with the model. Finally, I propose a quantitative investigation of the Korean surplus based on the asymmetric dynamics of trade costs between South Korea and its main trading partners. I develop a two‐country international real business cycle model augmented with trade costs. When fed with the actual asymmetric trends found in the data, the model generates a current account surplus of about 2.15% of GDP, roughly 66% of what was observed in the Korean data.

Exchange Rate Disconnect in General Equilibrium

We propose a dynamic general equilibrium model of exchange rate determination that accounts for all major exchange rate puzzles, including Meese-Rogoff, Backus-Smith, purchasing power parity, and uncovered interest rate parity puzzles. We build on a standard international real business cycle model with home bias in consumption, augmented with shocks in the financial market that result in a volatile near-martingale behavior of exchange rates and ensure their empirically relevant comovement with macroeconomic variables, both nominal and real. Combining financial shocks with conventional productivity and monetary shocks allows the model to reproduce the exchange rate disconnect properties without compromising the fit of the business cycle moments.

Common Trade Exposure and Business Cycle Comovement

A large empirical literature has shown that countries that trade more with each other have more correlated business cycles. We show that previous estimates of this relationship are biased upward because they ignore common trade exposure to other countries. When we account for common trade exposure to foreign business cycles, we find that (1) the effect of bilateral trade on business cycle comovement falls by roughly 25 percent and (2) common exposure is a significant driver of business cycle comovement. A standard international real business cycle model is qualitatively consistent with these facts but fails to reproduce their magnitudes. Past studies have used models that allow for productivity shock transmission through trade to strengthen the relationship between trade and comovement. We find that productivity shock transmission increases business cycle comovement largely because of a country-pair's common trade exposure to other countries rather than because of bilateral trade. When we allow for stronger transmission between small open economies than other country-pairs, comovement increases both from bilateral trade and common exposure, similar to the data.

High-Dimensional Dynamic Stochastic Model Representation

We propose a generic and scalable method for computing global solutions of nonlinear, high-dimensional dynamic stochastic economic models. First, within an MPI–TBB parallel time-iteration framework, we approximate economic policy functions using an adaptive, high-dimensional model representation scheme, combined with adaptive sparse grids. With increasing dimensions, the number of points in this efficiently-chosen combination of low-dimensional grids grows much more slowly than standard tensor product grids, sparse grids, or even adaptive sparse grids. Moreover, the adaptivity within the individual component functions adds an additional layer of sparsity, since grid points are added only where they are most needed — that is to say, in regions of the computational domain with steep gradients or at non-differentiabilities. Second, we introduce a performant vectorization scheme of the interpolation compute kernel. Third, we validate our claims with numerical experiments conducted on “Piz Daint (Cray XC50) at the Swiss National Super-computing Center. We observe significant speedups over the state-of-the-art techniques, and almost ideal strong scaling up to at least 1, 000 compute nodes. Fourth, to demonstrate the broad applicability of our method, we compute global solutions to two different versions of a dynamic stochastic economic model: a high-dimensional international real business cycle model with capital adjustment costs, and with or without irreversible investment. We solve these models up to 300 continuous state variables globally.

Dissecting Trade and Business Cycle Co-movement

Business cycles appear highly synchronized across countries. To understand this empirical phenomenon, I develop a multi-country international real business cycle model with international trade that offers several potential explanations: shocks to TFP, demand, leisure, investment, economic sectors, and bilateral trade. These shocks fully account for movements in gross domestic product and trade shares, completely describing the data during 1992-2014. Calibrating the model to a panel of developed (G7) countries, I find that openness to trade and the volatility of bilateral trade flows, which are manifested in bilateral trade shocks, are essential in synchronizing international business cycles. In contrast, other correlated country-specific shocks play relatively minor roles. This suggests that economic integration through trade has been the primary driver of the co-movement of business cycles internationally. I use my model to also address the \textit{trade co-movement puzzle}, which states that international real business cycle models should be predicting a much stronger link between trade and the correlation of business cycles. Once we account for the dynamics of the decline in trade costs and the volatility of bilateral trade flows, IRBC models do indeed predict a strong link between trade and business cycle co-movement. My finding suggests that more research on the dynamics of trade shocks is crucial when studying cross-country business cycle synchronization.

Endogenous Tradability, International Relative Prices, and the International Transmission of Business Cycles

This paper propose a two-country, dynamic, stochastic, general equilibrium (DSGE) model with endogenous tradability, product differentiation, variously determined physical capital, and an elastic labor supply to explore the propagation of business cycles across countries. The model successfully addresses international relative price dynamics (its appreciation with positive home productivity shock, called the ‘Harrod-Balassa-Samuelson Effect’) through the entry of producers and their cut-off productivities of exporting. The use of endogenous physical capital in the model induces a more realistic framework since the simulated model is compared to the U.S. investment data that covers spending on capital equipment, structures and inventories for producers’ entry and exit dynamics. Building the model with endogenous capital and elastic labor supply weakens the volatility of investment compared to conventional international real business cycle (IRBC) models. The model also accounts for several features of the data, such as the volatility of aggregate variables and their correlations with GDP.

Noisy information, risk sharing, and international business cycles

AbstractWe introduce a noisy information structure into an otherwise standard international real business cycle model with two countries. When domestic firms observe current foreign technology with some noise, predictions of the model on international correlation can be very different from those of a standard perfect information model. We show that the model can explain: (a) positive output correlation both in complete and incomplete market models, (b) consumption correlation smaller than output correlation with an introduction of information‐constrained consumers, and (c) observation of both positive and negative productivity–hours correlation in two countries.

Exchange Rate Disconnect in General Equilibrium

We propose a dynamic general equilibrium model of exchange rate determination, which simultaneously accounts for all major exchange rate puzzles. This includes the Meese-Rogoff disconnect puzzle, the PPP puzzle, the terms-of-trade puzzle, the Backus-Smith puzzle, and the UIP puzzle. We build on a standard international real business cycle model augmented with a financial sector with noise traders and risk-averse intermediaries, which results in equilibrium UIP deviations due to limits to arbitrage. We show that financial UIP shocks result in persistent near-martingale processes for exchange rates and ensure empirically relevant comovement properties between exchange rates and macro variables, including excess exchange-rate volatility relative to aggregate consumption and output. In contrast, conventional productivity and monetary shocks, while successful in explaining the international business cycle comovement, result in counterfactual exchange rate dynamics with insufficient volatility. As a result, when combined together, the two sets of shocks reproduce both the exchange rate disconnect behavior and the empirical business cycle properties. The transmission mechanism relies on a conventional Taylor rule, home bias in consumption, and muted pass-through of exchange rates into prices and quantities due to pricing to market and weak substitutability between home and foreign goods. Nominal rigidities improve somewhat the quantitative performance of the model, yet are not necessary for the exchange rate disconnect, as monetary shocks are not the key drivers of the exchange rate.

International Business Cycle and Financial Intermediation

AbstractThe paper extends a standard two‐country international real business cycle model to include financial intermediation by banks of loans and government bonds. The paper contributes an explanation for both the United States relative to the Euro‐area, and the United States relative to China, of cross‐country correlations of loan rates, deposit rates, and the loan premia. It shows a type of financial retrenchment for the United States relative to both Europe and China following a negative bank productivity shock, such as during the 2008 crisis. After 2008, results suggest that the Euro‐area has been more financially integrated with the United States, and China less financially integrated.

Aggregate volatility and international dynamics. The role of credit supply

Changes in country-specific aggregate volatility are positively correlated with the current account but negatively correlated with investment, output and credit flows. An International Real Business Cycle model with time-varying aggregate uncertainty, through a precautionary savings channel, can account for the positive correlation but implies counterfactual comovements for the other variables. Adding a credit supply channel with default and lenders exposed to aggregate risk allows the model to match all the facts. Higher volatility contracts credit supply and lowers investment and output. The current account turns to a surplus because savings increase, but also because investment collapses.

International Co-Movements in Recessions

Business cycle correlations are state-dependent and higher in recessions than in expansions. In this paper, I suggest a mechanism to explain why this is the case. For this purpose, I build an international real business cycle model with occasionally binding constraints on capacity utilization which can account for state-dependent cross-country correlations in GDP growth rates. The intuition is that firms can only use their machines up to a capacity ceiling. Therefore, in booms the growth of an individual economy can be dampened when the economy hits its capacity constraint. This creates an asymmetry that can spill-over to other economies, thereby creating state-dependent cross-country correlations in GDP growth rates. Empirically, I successfully test for the presence of capacity constraints using data from the G7 advanced economies in a Bayesian threshold autoregressive (T-VAR) model. This finding supports capacity constraints as a prominent transmission channel of cross-country GDP asymmetries in recessions compared to expansions.

Revisiting Real Exchange Rate Volatility: Nontraded Goods and Cointegrated TFP Chockse

International real business cycle (IRBC) models predict a real exchange rate volatility that is much lower than the levels observed in the data. In this paper, we build a two-country IRBC model with both a traded and a non-traded goods sector, and calibrate it to UK-euro area (EA) data. We provide evidence on the existence of a cointegrating relationship between UK and EA traded sector total factor productivity (TFP) by estimating a vector error correction model (VECM). To account for this relationship, we incorporate non-stationary technology shocks in the traded sectors in our model, and show that then the model is able to match the observed volatility of the UK-EA real exchange rate. Our analysis points out that both the presence of non-traded sectors and non-stationary technology shocks are necessary to account for the observed volatility in the real exchange rate.

The cause of an integral correction mechanism of the real exchange rate

I find that Rabanal and Rubio-Ramirez (2015)’s international real business cycle model can explain an integral correction mechanism of the real exchange rate. An input adjustment cost in their model implies that the real exchange appreciates following a positive domestic productivity shock and reverts to steady state quickly, but presents a long-run cyclical movement. These particular dynamics help explain the PPP puzzle.

Aggregate Volatility and International Dynamics. The Role of Credit Supply

Changes in country-specific aggregate volatility are positively correlated with current account dynamics while negatively correlated with investment, output and credit flows. An International Real Business Cycle model with time-varying aggregate uncertainty, through a precautionary savings channel, can account for the positive correlation but implies counterfactual comovements for the other variables. Adding a credit supply channel with default and lenders exposed to aggregate risk allows the model to match all the facts. Higher volatility contracts credit supply. The current account turns to surplus because savings increase, but also because investment collapses.

International Real Business Cycle Models with Incomplete Information

Standard international real business cycle (IRBC) models formulated by Backus, Kehoe, and Kydland (BKK, 1992) have been considered a natural starting point to assess the quantitative implications of dynamic stochastic general equilibrium (DSGE) models in an open economy environment. Since the standard IRBC model under assumptions of flexible prices and perfect competition cannot replicate all the observed characteristics of international business cycles, a number of extended models with more realistic features have been developed in the past two decades. We introduce a noisy information structure into an otherwise standard international real business cycle model with two countries. When domestic firms observe current foreign technology with some noise, predictions of the model on international correlation can be very different from those of a standard perfect information model. We show that the model can explain: (i) positive output correlation both in complete and incomplete market models; (ii) consumption correlation smaller than output correlation with an introduction of information constrained consumers; and (iii) observation of both positive and negative productivity-hours correlation in two countries.

Using Adaptive Sparse Grids to Solve High-Dimensional Dynamic Models

We present a exible and scalable method for computing global solutions of high-dimensional stochastic dynamic models. Within a time iteration or value function iteration setup, we interpolate functions using an adaptive sparse grid algorithm. With increasing dimensions, sparse grids grow much more slowly than standard tensor product grids. Moreover, adaptivity adds a second layer of sparsity, as grid points are added only where they are most needed, for instance in regions with steep gradients or at non-differentiabilities. To further speed up the solution process, our implementation is fully hybrid parallel, combining distributed and shared memory parallelization paradigms, and thus permits an efficient use of high-performance computing architectures. To demonstrate the broad applicability of our method, we solve two very different types of dynamic models: first, high-dimensional international real business cycle models with capital adjustment costs and irreversible investment; second, multiproduct menu-cost models with temporary sales and economies of scope in price setting.

THE ROLE OF INVESTMENT-SPECIFIC TECHNOLOGY SHOCKS IN DRIVING INTERNATIONAL BUSINESS CYCLES: A BAYESIAN APPROACH

This paper uses a Bayesian approach to estimate a standard international real business cycle model augmented with preferences with zero wealth effect, variable capacity utilization, and investment adjustment costs. First, I find that the bulk of fluctuations in country-specific outputs, consumption, investments, and international relative prices can be attributed to country-specific neutral technology, investment-specific technology, and preference shocks. Second, my estimated model with economically meaningful shocks simultaneously accounts for the negative correlation between the real exchange rate and relative consumption and the negative correlation between the terms of trade and relative output. Last, through a marginal likelihood comparison exercise, I find that the success of the model depends on preferences with zero wealth effects; other frictions and alternative asset market structures play a less important role.

The “Backus-Smith” puzzle, non-tradable output, and international business cycles

Purpose This paper aims to examine the effects of adding non-tradable sector and trade in intermediate goods sector and their impact on the “Backus-Smith” (BS) puzzle and the features of the non-tradable output. Conventional international real business cycle models show that the real exchange rate and the terms of trade are positively correlated to the relative consumption movement between the home and foreign economies when there is a total factor productivity shock, whereas the correlation in the data is negative. The author develops a two-country, dynamic, stochastic and general equilibrium (DSGE) model with staggered price setting in the non-tradable sector and international trade in intermediate goods sector because of product differentiation in a high-asset market frictions situation. Design/methodology/approach In this paper, DGSE simulation and calibration are performed using Matlab with Dynare. Findings When the world economy has positive country-specific productivity shock, the benchmark model with non-tradable sector and intermediate goods sector successfully solves the BS puzzle and is able to match several features of the data. The dynamic responses to productivity shock show that integrating product differentiation is necessary to generate a more volatile and counter-cyclical non-tradable output. Originality/value The paper investigates the effects of incorporating non-tradable sector and trade in interemediate goods sector to standard two-country DSGE model through simulation and calibration.