Sectoral Interdependence and Business Cycle Synchronization in Small Open Economies

Existing DSGE models are not able to reproduce the observed influence of international business cycles on small open economies. We construct a two-sector New Keynesian model to address this puzzle. The set-up takes into account intermediate trade and producer heterogeneity, where goods and service industries differ in terms of i) price flexibility, ii) trade intensity, iii) technology, iv) I-O structure, and v) the volatility of productivity innovations. The combination of intermediate markets and heterogeneous producers makes international business cycles highly important for the small economy, even if it has a large service sector. Exploiting I-O matrices of Canadian and US industries, the model is able to reproduce the role of international disturbances typically found in empirical studies. Model simulations deliver cross-country correlations in macroeconomic variables of about 0.7, with half of the variation in domestic variables attributed to foreign shocks.