Tastes and technology in a two-country model of the business cycle: Explaining international

TLDR

International financial trade lets households insure country‑specific risk and smooth consumption, yet standard equilibrium models predict near‑perfect consumption correlations and excessive investment volatility. Adding nontraded goods makes the model’s aggregate consumption, investment, and trade‑balance dynamics match industrialized‑country business‑cycle patterns, while technology shocks alone mis‑predict sectoral consumption‑price comovements; taste shocks, however, generate price‑quantity patterns that align with the data. © 1995 American Economic Association.

Abstract

Trade on international financial markets allows people to insure country-specific risk and smooth consumption intertemporally. Equilibrium models of business cycles with trade on global financial markets typically yield international consumption correlations near one and excessive volatility of investment. The authors incorporate nontraded goods in the model and find that the implications for aggregate consumption, investment, and the trade balance are consistent with business-cycle properties of industrialized countries. However, the model driven by technology shocks alone yields counterfactual implications for comovements between consumption and prices at the sectoral level. Taste shocks produce price-quantity relationships more consistent with the data. Copyright 1995 by American Economic Association.