Explaining International Business Cycle Synchronization

The business cycles of the major advanced economies are synchronized. Standard macro models fail to explain that fact. This paper presents a simple two-country, two-good, complete-markets dynamic general equilibrium model in which country-specific productivity shocks generate highly correlated business cycles. The structure here differs from standard open economy macro models by assuming recursive intertemporal preferences, and a weak wealth effect on labor supply. Recursive preferences magnify the terms of trade response to shocks. In the model here, a persistent productivity (and GDP) increase in a given country triggers a strong improvement of the foreign country’s terms of trade. When the wealth effect on labor supply is weak, this induces a rise in foreign hours worked and GDP, i.e. domestic and foreign real activity comove positively.