Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements

Trade on international financial markets allows people to insure country-specific risk and smooth consumption intertemporally. Equilibrium models of business cycles with trade on global financial markets typically yield international consumption correlations near 1 and excessive volatility of investment. We incorporate nontraded goods in the model and find that the implications for aggregate consumption, investment, and the trade balance are consistent with business-cycle properties of industrialized countries. However, the model driven by technology shocks alone yields counterfactual implications for comovements between consumption and prices at the sectoral level. Taste shocks produce price--quantity relationships more consistent with the data.