"Extraneous Shocks and International Linkage of Business Cycles in a Two-Country Monetary Model"

Abstract

The purpose of this paper is to analyze how changes in market psychology can be the source of world business cycles. The analysis is based on a two-country monetary model with the cash-in-advance constraint. In the model, we assume that international transmissions of the productivity shocks are small. However, when we investigate its dynamic property, we find that there exist stationary sunspot equilibria either when the relative risk aversion of the utility function is large or when positive external effects in production are large. In both cases, stationary sunspot equilibria are more likely outcome for the world aggregate output than for country-specific output. The result holds even when two countries do not have symmetric economic structure. Therefore, even if the fundamental value shows small cross-country output correlations, market psychology can cause large synchronization of business cycles under rational expectations.