By Federico S. Mandelman, Pau Rabanal, Juan F. Rubio-Ramírez and Diego Vilán
In this paper, we first introduce investment-specific technology (IST) shocks into an otherwise standard international real business cycle model and show that a thoughtful calibration of them along the lines of Raffo (2009) successfully addresses several of the existing puzzles in the literature. In particular, we obtain a negative correlation of relative consumption and the terms of trade (Backus-Smith puzzle), as well as a more volatile real exchange rate, and cross-country output correlations that are higher than consumption correlations (price and quantity puzzles). Then we use data from the Organisation for Economic Co-operation and Development for the relative price of investment to build and estimate these IST processes across the United States and a “rest of the world” aggregate, showing that they are cointegrated and well represented by a vector error–correction model. Finally, we demonstrate that, when we fit such estimated IST processes into the model, the shocks are actually powerless to explain any of the existing puzzles.
International real business cycle models have created more puzzles than explained things, and these puzzles have been very resilient despite years of research. Here, the authors stack all the cards towards explaining the puzzles: the puzzles are mostly due to productivity differentials across countries, which they perturb with investment-technology specific shocks. Unfortunately, empirically plausible shocks do not deliver, again.