Throughout the last 15 years international business cycle models have been used to analyze the international transmission of technology shocks. Irrespective of specific assumptions on the structure of international asset markets and on firm’s price setting behavior, these models generally provide a very similar account of how technology shocks impact the economy and are propagated over time and across countries. This standard transmission mechanism can be summarized as follows: In response to a country specific positive technology shock, domestic output expands and its relative price falls (i.e. the domestic terms of trade depreciate).
At the same time, a surge of investment induces a trade deficit, which turns into a surplus once the domestic capital stock has been built up. Under this transmission mechanism, foreign residents will generally reap some of the benefits of domestic technology shocks even in the absence of explicit risk-sharing, because the depreciation of the terms of trade increases the relative value of foreign output.
The empirical success of models based on this transmission mechanism has been mixed. In a seminal contribution Backus, Kehoe and Kydland (1994), hereafter BKK, show that the frictionless, complete markets variant of the model fails to replicate several key properties of the data, notably the volatility of relative prices.
At the same time BKK emphasize that—conditional on technology shocks—the model delivers the S-curve, i.e. an S-shaped cross orrelation function for the trade balance and the terms of trade. The S-curve is ‘one of the striking features of the data’ (BKK, p. 93), and turns out to be robust both across countries and sample periods. As a stylized fact characterizing international business cycles, it will also play a key role in the assessment of the international transmission mechanism provided by the present paper.
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On the International Transmission of Technology Shocks
