International Business Cycles

1. International Business Cycles Jean-Olivier HAIRAULT, Professeur à Paris I Panthéon-Sorbonne et à l’Ecole d’Economie de Paris (EEP)

2. Introduction : Topic and Issues • International business cycles: focus on economic connections among countries • In the academic studies, this focus is expressed in terms of the volatility and comovements of international time series data. For instance, the correlation of main aggregates across countries (consumption, output,….) (First class) • but also the volatility of the exchange rates and the terms of trade as well as the pattern of the trade balance in the business cycles. (Second class)

3. Introduction: Topic and Issues • How to define the international business cycle? What are the stylized facts that any theoretical model should aim to replicate? • What are the factors behind international business cycles: real or financial; budgetary or monetary? • Are the international fluctuations optimal or the « proof » that the economic system is characterized by inefficiencies? • Is there a need to stabilize or to coordinate? Are there international business cycles (welfare) costs? • What are the policies likely to stabilize the international business cycle? Beyond smoothing output dynamics, stabilization policies must increase welfare.

4. Introduction : Topic and Issues • From a methodologicalstandpoint, international business cycles are consideredfrom the perspective of dynamicstochasticgeneralequilibriummodels. • In line withKydland and Prescott works (RBC theory), 1982, Time to Build and Aggregate Fluctuations, Econometrica. • Backus, Kehoe and Kydland: International Real Business Cycles , 1992, Journal of PoliticalEconomy; Baxter and Crucini, Business Cycles and the Asset Structure of Foreign Trade, 1995 International Economic Review, Backus, Kehoe and Kydland, International Business Cycles: Theory and Evidence (1995) in Frontiers of Business Cycles Research (Cooley, ed.), Baxter, International trade and business cycles, 1995 in the Handbook of International Economics • Obstfeld and Rogoff, Foundations of International Macroeconomics, 1996, Mit Press.

5. A quick presentation of the RBC approach • F. Kydland and E. Prescott, 1982, Econometrica, Nobel Prize in 2005. • In the line of the Lucas critique to Keynesianism: Building a model with explicit micro-foundations taking part in the general equilibrium analysis: market clearing, no monetary factors, at odds with keynesian tradition. • One-step forward : no rationale for macroeconomic management = the optimal growth model with short-run fluctuations induced by productivity shocks (stochastic neoclassical growth model in the line of Solow (1956), Cass (1965) and Brock-Mirman (1972)). Hard-core of the RBC approach which has been challenged by a lot of works. • No more methodological opposition between business cycle and growth research which was at the heart of the neoclassical synthesis. • Building a successful (relative to data) business cycle model: imposing a new method based on calibration to evaluate the performance of business cycle models relative to a new definition of the business cycle facts. Quantitative Approach. • The methological innovation has been criticized but is now extensively used in macroeconomics today, even by proponents of stabilization interventions. The methods initiated by Kydland and Prescott are now commonly used in monetary and international economics, public finance, labor economics, asset pricing. In contrast to early RBC studies, they involve market failures so that government interventions are desirable.

6. A quick presentation of the RBC approach • Shock-based approach : productivity shocks • Propagated by intertemporal choices derived from dynamic optimization under rational expectations. • Studying the canonical model first presented by King, Plosser and Rebelo (1988), Journal of Monetary Economics and reconsidered in King and Rebelo (1999), Handbook of macroeconomics. • See my web page for a detailed presentation of this approach.

7. Intertemporal choices and asset market are central for international macroeconomics • The role of international asset markets is central in allowing countries to trade consumption goods over time by borrowing from and lending to each other. • Intertemporal approach of the international macroeoconomics (particularly emphasized by Obstfeld and Rogoff, but initiated by Backus, Kehoe and Kydland and the RBC theory • The basics: chapter 1, 2 and 5 of Obstfeld and Rogoff’s book.

8. Some basics on intertemporal choices • One good, either consume or invest • Two periods 1 and 2 • No uncertainty • U’(C1) = (1+r) b U’(C2) Euler Condition • Let us consider the illuminating case (1+r) b=1. Consumers perfectly smooth their consumption flows over time periods. They trade consumption goods over time by lending or borrowing in the international financial markets • F’(K) - d = r capital demand condition

9. Some basics on intertemporal choices International AssetMarketEquilibrium: S+S*=I+I* or S-I = -(S*-I*) or CA = -CA* for r=re Home country has a currentaccount surplus, Foreign country a deficit in line with comparative advantage (ra<ra*, presentconsumptionpriceislower in the Home Country in autarky) S* I * I S ra* CA re ra -CA*

10. Some basics on intertemporal choices Let us consider a temporary increase in the home productivity at period 1. More current income will increase home savings and then will decrease the equilibrium interest rate I * I S* S CA -CA* S’ Note that home investment is not affected by a purely transitory productivity shock. Home investment increases due to the decrease in the interest rate. The foreign current account deficit increases. (corr(I,I*) and corr(C,C*) >0 in this case)

11. Some basics on intertemporal choices Let us consider a future increase in Home productivity. Home investment increases (investment curve shifts to the right) whereas home saving decreases I * S* I S The world equilibrium interest rate is then higher. Note that Home investment does not necessarily increase because of the higher interest rate. There is a current account surplus (deficit) for Foreign (Home) (corr(I,I*) <0 and corr(C,C*) <0 in this case)

12. Some basics on intertemporal choices • Let us consider a permanent shock. Only the investment curve shifts to the right. The world interest rate increases, leading to increase savings in both countries. • Note that corr(I,I*)<0 and corr(C,C*) <0 in this case S* I * I S

13. International Real Business Cycles • Two-country, one good model: two-country RBC model, BKK, 1992, JPE • Without any nominal features, in particular no nominal exchange rate • No real exchange rate too: only one good • Studying the comovement between main aggregates across countries • Are international business cycles optimal and driven by productivity shocks?

14. International Real Business Cycles • International financial integration is an important issue for international business cycles since financial markets can allow agents to smooth consumption in response to country-specific income shocks. • Stochastic productivity: uncertainty • Most of inter. Bus. Cycl models assume that agents have access to complete international contingent-claims markets which permit them to perfectly pool country-specific shocks • Is this feature essential to understand their predictions, and their shortcomings? To compare to a model with an incomplete access to international risk sharing. Baxter and Crucini, IER, 1995

15. International Real Business Cycles • Quantitative approach: comparing the empirical predictions of the model to facts • Calibration and simulation of the model • The business cycle is captured by second order moments: standard deviation (volatility), serial correlation (persistence), correlation (comovement) • These moments capture the business cycles of each economy and the international business cycle • What are the stylized facts? • What is the definition of the business cycle?

16. Measuring cycles by using HP filter • More than identifying the non-stationarity of series, we need an economic definition of business cycles consistent with the decades of works following the seminal approach of Burns and Mitchell (NBER tradition). • The HP filter can make stationary series up through four orders of integration. • It is flexible enough to remove the « undesired » long-run frequencies of the stationnary component of series. • See F. Canova [1998] for a detailed analysis of the HP filter. Journal of Monetary Economics • See M. Baxter and R. King [1999], Review of Economics and Statistics.

17. Measuring cycles by using HP filter

18. Measuring cycles by using HP filter

19. Measuring cycles by using HP filter • To understand how HP filter works, it may be useful to compare with the measure resulting from a band-pass filter procedure: the HP filter looks like a BP filter which makes the cyclical component those parts of output with periodicities between 6 and 32 quarters: high frequencies like seasonnal frequencies and low frequencies are removed

20. Business Cycles in 10 developed countries

21. International Comovements

22. Presentation of a canonical two-country RBC model

23. Presentation of a canonical two-country RBC model

24. Presentation of a canonical two-country RBC model

25. Presentation of a canonical two-country RBC model

26. Presentation of a canonical two-country RBC model

27. Presentation of a canonical two-country RBC model

28. The quantity anomaly the ranking of output and consumption correlations across countries is at odds with the stylized facts, whatever the degree of completness of financial markets

29. The quantity anomaly • Whenthereis a positive productivityshock in HC, capital and labordemandincreases. This pushes up the world interest rate. • When the productivityshockistransitory, home consumerssmooththeirconsumtionstreams by saving more. This moderates the increase in the world interest rate due to the increase in Home investment. • As the world interest rate increases, the investmentdecreases in the FC. • Withcompletemarkets, foreignhouseholds consume more and workless: with CM, correlationbetweenconsumption are positive (evenunitary for the separable utility function) and negative for investment and labor. • This isalso the case whenfinancialmarkets are incomplete. Due to the spillovereffect (rho *>0), the productivityshock has an effectabroad in the future. This explainswhyitgenerates a positive wealtheffectevenwhen the markets are incomplete. As foreignconsumers have access to financialmarket, theyaccumulatedebtwhichallowsthem to increasetheirconsumptiontoday. The correlationbetweenconsumptionishigheven in the case of incompletemarkets.

30. The quantity anomaly

31. The importance of the productivity process: the permanent shock case

32. The importance of the productivity process: the permanent shock case When the productivity shock is permanent, Home consumers do not increase their savings. As the investment increases, the home current account is negative and the world interest rate increases.

33. The importance of the productivity process: the permanent shock case With contingent claim markets, Foreign consumption increases. With incomplete markets, as the interest rate increases, foreign consumers reduce their current flows of consumption.

34. The importance of the productivity process: the permanent shock case With complete markets, there is risk (wealth) sharing, the wealth effect is weaker at home, where the productivity effect dominates for labor decisions. Abroad the positive wealth effect explains the decrease in labor supply. With incomplete markets, there is a strong positive wealth effect on labor supply which explains the decrease in Home labor.

35. The importance of the productivity process: the permanent shock case With complete markets, as labor increases in HC, the response of Home investment is higher. Abroad, with complete markets, labor decreases, and this decreases the capital productivity.

36. The importance of the productivity process: the permanent shock case The output responses result from the behavior of investment and labor.