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

Abstract

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.