International business cycles: Information matters

We propose a mechanism that explains standard stylized facts in both international macroeconomics and international finance. To do so, we develop a New Keynesian DSGE model with financial frictions à la Bernanke et al. (1999), in which we depart from the full-information rational expectations (FIRE) assumption. The key ingredient is home information bias (HIB) in expectations. While the FIRE model predicts high consumption co-movements, no departure from uncovered interest parity (UIP) and procyclical trade balance, assuming HIB makes the model consistent with the data by producing low consumption correlation, solving the quantity puzzle, generating endogenous departures from the UIP and matching a countercyclical trade balance. The mechanism is empirically validated and shown to be robust to the extent of frictions in the economy.