AGENCY COSTS, RISK SHOCKS, AND INTERNATIONAL CYCLES

What is it about?

We add agency costs into a two-country, two-good international business-cycle model. In our model, changes in the relative price of investment arise endogenously. Despite the fact that technology shocks are uncorrelated across countries, the relative price of investment is positively correlated across countries in our model, much as it is in detrended U.S./Euro-area data. We also find that financial frictions tend to increase the volatility of the terms of trade and the international correlations of consumption, hours worked, output, and investment.

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Why is it important?

Up until a few years ago, models trying to explain international business cycles could not explain fluctuations in the relative price of investment (RPI), they simply took them as given. While this was a convenient shortcut, it did not line up with an economics’ student intuition that prices are actually determined by market forces. In our work we take a standard model of the US and Europe and add to it a more realistic financial sector. Our model is one of the first international business cycle models to actually explain fluctuations in the RPI instead of taking them as given. In our model, it is the demand for investment goods as well as the investment-goods producers’ facility or difficulty to borrow from banks that determine the price of investment goods.