International Business Cycles Jean-Olivier HAIRAULT, Professeur à Paris I Panthéon-Sorbonne et à...

International Business Cycles

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

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)

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.

Introduction : Topic and Issues

From a methodological standpoint, international business cycles are

considered from the perspective of dynamic stochastic general

equilibrium models.

In line with Kydland and Prescott works (RBC theory), 1982, Time to

Build and Aggregate Fluctuations, Econometrica.

Backus, Kehoe and Kydland: International Real Business Cycles ,

1992, Journal of Political Economy; 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.

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.

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.

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.

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

Some basics on intertemporal choices

International Asset Market Equilibrium:

S+S*=I+I* or S-I = -(S*-I*) or CA = -CA* for r=re

Home country has a current account surplus, Foreign country

a deficit in line with comparative advantage (ra<ra*, present consumption price is lower in the Home Country in autarky)

S

II * S*

ra*

rare

CA

-CA*

Some basics on intertemporal choices

SI

I *

S*

CA

-CA*S’

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

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)

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

SI

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)

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

SI I * S*

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?

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

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?

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.

Measuring cycles by using HP filter

Measuring cycles by using HP filter

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

Business Cycles in 10 developed countries

International Comovements

Presentation of a canonical two-country RBC model

Presentation of a canonical two-country RBC model

Presentation of a canonical two-country RBC model

Presentation of a canonical two-country RBC model

Presentation of a canonical two-country RBC model

Presentation of a canonical two-country RBC model

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

The quantity anomaly

When there is a positive productivity shock in HC, capital and labor demand increases. This pushes up the world interest rate.

When the productivity shock is transitory, home consumers smooth their consumtion streams 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 investment decreases in the FC.

With complete markets, foreign households consume more and work less: with CM, correlation between consumption are positive (even unitary for the separable utility function) and negative for investment and labor.

This is also the case when financial markets are incomplete. Due to the spillover effect (rho *>0), the productivity shock has an effect abroad in the future. This explains why it generates a positive wealth effect even when the markets are incomplete. As foreign consumers have access to financial market, they accumulate debt which allows them to increase their consumption today. The correlation between consumption is high even in the case of incomplete markets.

The quantity anomaly

The importance of the productivity process: the permanent shock case

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.

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.

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.

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.

The importance of the productivity process: the permanent shock case

The output responses result from the behavior of investment and labor.