The international transmission of economic fluctuations:

Abstract

This paper suggests that for a wide class of international real-business-cycle models, including models with imperfect competition, the traditional channels of international transmission of business cycles through world-interest-rate and terms-of-trade variations cannot explain the cyclical response of the Canadian economy to innovations in U.S. output. Empirically testable quantitative models of the effects on Canadian economic activity of shocks to the U.S. economy are developed and their empirical relevance is tested by comparing impulse responses estimated from vector autoregressions to the quantitative predictions of the theoretical models.

Introduction

Can trade alone explain the cross-country comovements of macroeconomic aggregates at business-cycle frequencies? This paper suggests that for a wide class of international real business-cycle models, including models with imperfect competition, the answer is no. The paper examines whether international trade in goods and financial markets can account for the observed effects of U.S. business cycles on the Canadian economy in a setting in which trade transmits cyclical fluctuations through its effects on world interest rates and relative prices.

Cross-country business-cycle correlations have been widely documented, and empirical studies consistently find that cyclical variations in output and other macroeconomic aggregates are positively correlated across countries. Attempts to explain these correlations in a dynamic equilibrium-business-cycle framework have been made by a number of recent authors (for example, Backus et al., 1992Stockman and Tesar, 1995).¹ In most of this literature, however, the only implications of the theoretical models that are examined are the implied correlation and relative volatility properties of macroeconomic time series when the model economy is subjected to technology or taste disturbances. Such analyses test a complex joint hypothesis, involving specification of both the transmission mechanism and the set of exogenous shocks generating short-term fluctuations in different countries. This paper, in contrast, tries to isolate the importance of the transmission mechanism and asks whether it alone can explain the effects of foreign business cycles on the home economy. Transmission mechanism here means the propagation of shocks in a foreign economy to domestic endogenous variables through international trade in goods and financial markets and through effects on world relative prices.

In the case of any given equilibrium model, one can ask how a shock affecting output in a foreign country affects equilibrium in the home country. This implication of the model can furthermore be tested assuming that one is able to identify shocks of the particular type being considered. An empirical strategy of this kind has the appealing feature that one does not have to specify the complete set of shocks that generate short-term fluctuations—not even the complete set of shocks affecting the home economy. By contrast, the set of predictions tested in the literature just cited depends upon specification of the complete set of shocks affecting both countries.

If both countries under consideration are large, then a shock that directly affects output in the foreign economy may be hard to identify because it might be caused by economic conditions in the home country. However, for a small-large country pair, a shock in the large economy can be identified because one has little reason to believe that such a shock represents responses to the small country's economic conditions. This identification problem suggests to consider small–large country pairs in which the large country is an important trading partner of the small country. The Canadian and U.S. economies accordingly form a suitable small–large country pair. Furthermore, many authors have discussed the effects on Canadian economic activity of changes in U.S. output, and U.S. business cycles have often been assigned an important role in the generation of aggregate fluctuations in Canada in the recent decades (see, for example, Burbidge and Harrison, 1985, Ambler, 1989, Johnson and Schembri, 1990). The empirical analysis therefore focuses on the transmission of U.S. fluctuations to the Canadian economy.

Impulse responses estimated in this paper show that Canadian output, employment, investment, exports, imports, and terms of trade (measured as the ratio of export to import prices) respond positively to a positive innovation in U.S. gross national product (GNP). The paper analyzes the ability of three transmission channels to explain these observed responses: (1) Financial markets: shocks to the U.S. economy affect the Canadian economy through changes in the rate of return on international financial assets available to Canadian agents; (2) Export markets: shocks to the U.S. economy affect Canadian activity through changes in the terms of trade in response to variations in export demand; (3) Imperfectly competitive export markets: shocks to the U.S. economy affect the Canadian economy through changes in export demand and in market power of imperfectly competitive export producers.

The financial market transmission channel represents the simplest hypothesis, as it is consistent with the assumptions of a single internationally traded good and perfect competition (though it requires neither). I thus consider this channel first in the context of a competitive one-sector model, an analytical framework that has been extensively used to explain various international business-cycle regularities.² In the one-sector model, changes in investment opportunities in the foreign economy, which may include a revaluation of the agents' international portfolios, are the only potential explanation for the international transmission of business cycles besides correlation of the underlying shocks. The computed model impulse responses show that this channel fails to match the estimated responses of output, investment, and employment simultaneously.

To analyze whether business cycles are transmitted through variations in export demand, the one-sector framework is extended to include two goods, one produced exclusively in Canada (Canada's export good) and one supplied elastically to Canada on a world market (Canada's import good). The paper shows that transmission through export-demand variations accounts better for the behavior of output and hours than transmission through financial markets; however, the quantitative predictions for output and hours are still weaker than the estimated ones.

In the two-good competitive-equilibrium model, variations in export demand affect equilibrium in the Canadian economy only through their effects on the terms of trade. If one assumes that exporters have market power and that the market structure is like that in the implicit collusion model of Rotemberg and Woodford (1992), then variations in export demand affect the domestic economy through terms-of-trade and also through markup changes. This transmission channel can quantitatively explain the observed responses of investment, output, and hours, but it still fails to explain the behavior of exports and the terms of trade. Therefore the basic conclusion of the paper is unaffected by the introduction of imperfect competition and implicit collusion among exporters: In international real business-cycle models, the traditional channels of transmission, namely price variations (that is, interest rate and terms-of-trade variations), fail to explain the cyclical response of the Canadian economy to innovations in U.S. output.

The remainder of the paper is organized in four sections. Section 2develops the baseline one-sector, small-open-economy model. Section 3describes the procedure for testing the empirical relevance of the various transmission channels by applying it to the interest rate channel. Section 3first presents the estimation of the impulse responses of Canadian macroeconomic aggregates to an innovation in U.S. output. Second, it describes the calibration of the model and the computation of the predicted impulse responses to an innovation in U.S. output. Third, it illustrates the way these two sets of impulse responses are used to test the success of the financial market or interest rate transmission channel. In Section 4, the basic model is extended and the hypothesis that transmission through export-demand variations, transmission through variations in export demand when exporters have market power, or transmission through both financial markets and export-demand variations can explain the observed effects of a U.S. output innovation on the Canadian economy is tested. Section 5concludes the paper.