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Can Indeterminacy Resolve the Consumption Correlation Puzzle?

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  • Wei Xiao
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Abstract

Do international business cycles only represent optimal responses by rational agents to erratic changes in technology, or are they also influenced by factors that are unrelated to fundamentals? This paper addresses this issue by exploring the role of such non-fundamental factors in improving open-economy real business cycle (RBC) models. One major shortcoming of existing RBC models is the "consumption correlation puzzle" - models tend to generate cross-country consumption correlations that are too high and output correlations that are too low. I show that with empirically supported level of increasing returns, an otherwise standard model possesses multiple equilibria and indeterminate convergent paths to the steady states, which allows for "self-fulfilling beliefs" to influence the economy. The model displays time series properties that in many ways match the data better than the conventional model. It is especially successful in generating realistic consumption and output correlations.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2001 with number 209.

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Date of creation: 01 Apr 2001
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Handle: RePEc:sce:scecf1:209

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Keywords: Indeterminacy; sunspots; international correlations;

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  1. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  2. Roger E.A. Farmer & Jang Ting Guo, 1992. "Real Business Cycles and the Animal Spirits Hypothesis," UCLA Economics Working Papers 680, UCLA Department of Economics.
  3. Baxter, M. & Crucini, M., 1991. "Business Cycles and the Asset Structure of Foreign Trade," RCER Working Papers 316, University of Rochester - Center for Economic Research (RCER).
  4. Harrison, Sharon G., 2001. "Indeterminacy in a model with sector-specific externalities," Journal of Economic Dynamics and Control, Elsevier, vol. 25(5), pages 747-764, May.
  5. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1991. "International real business cycles," Staff Report 146, Federal Reserve Bank of Minneapolis.
  6. Jess Benhabib & Roger E.A. Farmer, 1992. "Indeterminacy and Increasing Returns," UCLA Economics Working Papers 646, UCLA Department of Economics.
  7. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1992. "Relative Price Movements in Dynamic General Equilibrium Models of International Trade," NBER Working Papers 4243, National Bureau of Economic Research, Inc.
  8. Benhabib, Jess & Nishimura, Kazuo, 1998. "Indeterminacy and Sunspots with Constant Returns," Journal of Economic Theory, Elsevier, vol. 81(1), pages 58-96, July.
  9. Domowitz, Ian & Hubbard, R Glenn & Petersen, Bruce C, 1988. "Market Structure and Cyclical Fluctuations in U.S. Manufacturing," The Review of Economics and Statistics, MIT Press, vol. 70(1), pages 55-66, February.
  10. Wen, Yi, 1998. "Capacity Utilization under Increasing Returns to Scale," Journal of Economic Theory, Elsevier, vol. 81(1), pages 7-36, July.
  11. Bennett, R.L. & Farmer, R.E.A., 1999. "Indeterminacy with Non-Separable Utility," Economics Working Papers eco99/34, European University Institute.
  12. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  13. Susanto Basu & John G. Fernald, 1996. "Returns to scale in U.S. production: estimates and implications," International Finance Discussion Papers 546, Board of Governors of the Federal Reserve System (U.S.).
  14. Alan C. Stockman & Linda L. Tesar, 1990. "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," NBER Working Papers 3566, National Bureau of Economic Research, Inc.
  15. Robert Kollmann, 1996. "Incomplete asset markets and the cross-country consumption correlation puzzle," ULB Institutional Repository 2013/7640, ULB -- Universite Libre de Bruxelles.
  16. Baxter, M. & Crucini, M.J., 1990. "Explaining Saving/Investment Correlation," RCER Working Papers 224, University of Rochester - Center for Economic Research (RCER).
  17. Guo, Jang-Ting & Sturzenegger, Federico, 1998. "Crazy Explanations of International Business Cycles," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(1), pages 111-33, February.
  18. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, December.
  19. Finn, Mary G., 1999. "An equilibrium theory of nominal and real exchange rate comovement," Journal of Monetary Economics, Elsevier, vol. 44(3), pages 453-475, December.
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