Dissecting Trade and Business Cycle Co-movement

By Paul Hilhak Ko

http://d.repec.org/n?u=RePEc:jmp:jm2020:pko1026&r=dge

International business cycles have become highly synchronized across countries in the past three decades, yet there is a lack of consensus on whether this is due to an increase in the correlation of country-specific shocks or due to increased economic integration. To understand this empirical phenomenon, I develop a multi-country real business cycle model with international trade that captures several potential explanations: shocks to productivity, demand, leisure, investment, sectoral expenditures, and trade- linkages. By matching the data exactly with the endogenous outcomes of the model, shocks fully account for the data such as GDP and trade shares. Calibrating the model to a panel of developed (G7) countries during 1992-2014, I find that trade-linkage shocks, which capture the increased economic integration and volatility of trade flows, are essential in synchronizing international business cycles. In contrast, other correlated country-specific shocks play relatively minor roles. This suggests that trade shocks through economic integration have been the primary driver of the co-movement of international business cycles. Furthermore, I use my model to address the trade co-movement puzzle, which states that international real business cycle models should be predicting a much stronger link between trade and cross-country GDP correlations. Once I account for the trade-linkage shocks, the model predicts a strong link between trade and business cycle co-movement. This finding suggests that incorporating the dynamics of trade shocks is crucial when studying international business cycles.

I started my career with international RBC models, but soon left the field because I saw little left to say and some fundamental flaws in the models that could not be addressed. Well, as for other puzzles in Economics, you just give it a few decades and eventually this become interesting again, and the literature manages to gnaw at the puzzles. This paper shows nicely where this literature is now and what it can contribute again.

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