International Linkages of Business Cycles

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The purpose of this project was to investigate whether changes in market psychology can be another source of world business cycles even if agents form rational expectations. The model was based on a two-country monetary model with country-specific cash-in-advance constraints. We assumed that international transmission of economic fluctuations was not large. We then investigated the dynamic property of this two country monetary model and explored the implications of extraneous (non-fundamental) shocks for world business cycles. In the following two-country model, productivity shocks always had strong positive impacts on the domestic output. However, international transmissions of the productivity shocks were small under reasonable parameters. Therefore, unless productivity shocks were highly correlated across countries, it was unlikely that the fundamental value of output in country 1 had a strong correlation with that in country 2. However, when we investigated the dynamic property of this monetary model, we found that there existed stationary sunspot equilibria either when the relative risk aversion of the utility function was large or when positive external effects in production were large. In both cases, stationary sunspot equilibria were more likely outcome for the world aggregate output than for country-specific output. This was because a raise of the expected future domestic output had a positive impact on both domestic and foreign current outputs. However, even the international linkage was small, extraneous uncertainty tended to cause strong synchronization of business cycles.