Can Indeterminacy and Self-Fulfilling Expectations Help Explain International Business Cycles?

Stephen McKnight
2016 Social Science Research Network  
We introduce equilibrium indeterminacy into a two-country incomplete asset model with imperfect competition and analyze whether self-fulfilling, belief-driven fluctuations (i.e., sunspot shocks) can help resolve the major puzzles of international business cycles. In contrast to the one-good models of the existing literature, we show that sunspot shocks alone cannot replicate the data. Next, we consider a combination of sunspot shocks and technology shocks, and find that the indeterminacy model
more » ... ndeterminacy model can now account for the counter-cyclical behavior observed for the terms of trade and real net exports, while simultaneously increasing their volatilities relative to output. The empirical success of the model is due to an unconventional transmission mechanism, whereby the terms of trade appreciates, rather than depreciates, in response to a positive technology shock. This unconventional feature, when combined with sunspot shocks, helps to reconcile the model with the data. However, the major failure of the model is its inability to resolve the Backus-Smith puzzle without a strongly negative cross-country correlation for productivity shocks.
doi:10.2139/ssrn.2876684 fatcat:vtxqq5ifyfbtxn3xjbpjlwt3aq