Comparing General and Partial Equilibrium Approaches to the Study of Real Business Cycles

The international financial crises and deepening world-wide recession remind us that the economic fates of nations are tightly linked. How do different models perform in explaining correlated business cycles? This paper compares the performance of two types of international real business cycle models, namely two-country dynamic stochastic general equilibrium (DSGE) and small open economy (SOE) models in explaining the shock transmission mechanisms across countries, using 68 countries' output and consumption data from the Penn World Table (PWT). In particular, we put our emphasis on the two types of models that have both permanent and transitory components of productivity shocks. In the two-country DSGE model, comovement of business cycles among different countries can be captured by correlated permanent and transitory components of productivities across countries. On the other hand, in the SOE model, comovement of economies can only be modeled through the channel of world interest rate shock. Our evidence shows that the interest rate shock has very limited impact on output growth. Therefore, the two-country DSGE model outperforms the SOE in capturing the effects of the permanent shocks originated from foreign countries, especially for the developed countries, which are highly integrated with each other.