Real Business Cycles in a Small Open Economy with Non-Traded Goods

The Israeli economy business cycle properties are different from those of most OECD countries in four main dimensions. Aggregate consumption is twenty percent more volatile than output, the trade balance is much more volatile than output and is procyclical, investment is almost five times more volatile than output, and the auto-correlation in output is low. The puzzle that these observations imply is explained in this paper by the result that with three parameters of a CES utility function and the share of non-traded goods in government expenditures, one can get almost any volatility in consumption, holding constant the production side parameters. Alternative values of the CES utility parameters drastically affects the consumer decision on shifting the traded goods consumption in response to shock in both sectors. The main result is that the model fits all the main business cycle properties of the Israeli economy, described above.