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Limited participation in international business cycle models: A formal evaluation

  • Gao, Xiaodan
  • Hnatkovska, Viktoria
  • Marmer, Vadim

In this paper, we argue that limited asset market participation (LAMP) plays an important role in explaining international business cycles. We show that when LAMP is introduced into an otherwise standard model of international business cycles, the performance of the model improves significantly, especially in matching cross-country correlations. To perform formal evaluation of the models we develop a novel statistical procedure that adapts the statistical framework of Vuong (1989) to DSGE models. Using this methodology, we show that the improvements brought out by LAMP are statistically significant, leading a model with LAMP to outperform a representative agent model. Furthermore, when LAMP is introduced, a model with complete markets is found to do as well as a model with no trade in financial assets – a well-known favorite in the literature. Our results remain robust to the inclusion of investment specific technology shocks.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 39 (2014)
Issue (Month): C ()
Pages: 255-272

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Handle: RePEc:eee:dyncon:v:39:y:2014:i:c:p:255-272
Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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