International Business Cycles with Frictions in Goods and Factors Markets

This paper explores the impact of frictions in the market for final goods and factors of production on international transmission of business cycles. In particular, I analyze the role of habits in consumption, capital adjustment costs and labor market frictions in the form of habits in leisure or labor adjustment costs, in a standard international real business cycles model with complete markets. Overall, these frictions that help explain many salient facts of a closed-economy have less success in resolving international comovement puzzles. Specifically, I find that capital adjustment costs together with consumption habits help explain positive investment comovement only – in combination with capital adjustment costs, consumption habits provide a channel through which capital adjustment costs become larger than the opportunity costs of not investing in a more productive country. However, resolving the investment puzzle comes at the expense of aggravating other comovement problems. In addition, I find that frictions in the labor market do not help to explain factor comovements such as the employment and investment puzzle. Furthermore, while both labor adjustment costs and leisure habits increase the output correlation, only the effects of the latter present forces toward resolving the consumption cross-correlation puzzle (although not actually resolving it). This mainly comes as a result of leisure habits reducing the consumption correlation through amplified effects on the nonseparability of consumption and leisure.