Multiple stages of processing and the quantity anomaly in international business cycle models

We construct a two-country DSGE model with multiple stages of processing and local-currency staggered price-setting to study cross-country quantity correlations driven by monetary shocks. The model embodies a mechanism that propagates a monetary surprise in the home country to lower the foreign price level while restraining the home price level from rising too quickly. It does so through reducing material costs in terms of the foreign currency unit while dampening the upward movements in the costs in terms of the home currency unit, both in absolute terms and relative to the costs of primary factors. We show that, through this mechanism and a resulting factor substitution effect, the model is able to generate significant cross-country quantity correlations, with correlations in consumption considerably lower than correlations in output, as in the data.