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We are grateful to Susanna Mursula and Jeffery Gable for help with gathering the data, to Helen Hwang for preparing the tables, to Francesco Caramazza, David T. Coe, Peter Isard, Paul Masson, and Hossein Samiei for comments, and to Tamim Bayoumi, Geert Bekaert, Peter Clark, and Robert Kollmann for helpful discussions. The opinions and errors are the authors’ alone.
Obstfeld (1980, 1982) has analyzed consumption smoothing in deterministic dynamic models with agents optimizing over their entire life span. For more recent work in this area see, among others, Bayoumi and MacDonald (1994), Bayoumi and Klein (1995), and Ostry (1988).
Cochrane’s Vk-statistics is a non-parametric measure for the persistence in a time series process. It is defined as
Following Stockman and Tesar (1995), tradables output is defined as the sum of output in the following sectors: (1) agriculture, hunting, forestry and fishing; (2) mining; (3) manufacturing; (4) wholesale and retail trade, restaurants, and hotels; and (5) transport, storage, and communication. Output of nontradables comprises (1) electricity, gas and water; (2) construction; (3) finance, insurance, real estate and business services; (4) community, social, and personal services; and (5) government services. The sectoral data are taken from the OECD Annual National Accounts Database, the net foreign asset position data taken from Masson, Kremers and Home (1993). See the appendix in Turtelboom (1995) for a detailed description of the data and sources.
We use a weight for the relative variance of the growth component to the cyclical component of 100 in the calculation of the trend component, as it is standard in the literature. Baxter and King (1995), show that a weight of 10 comes close to replicating the properties of an ideal band-pass filter for the extraction of business cycle frequencies. We test the robustness of our result with respect to the weight chosen below.
Stockman and Tesar (1995), who have a larger set of countries, do not obtain such a clearcut picture in their data: the correlation in the output of traded goods in one country with the output of nontraded goods in another is sometimes larger than the correlation between the outputs of traded goods in the same two countries.
Real consumption based interest rates are ex post real interest rates based on a CPI inflation measure.
A lack of data prevented us from calculating an aggregate net foreign asset position for the rest of the world.
For comparison, for an AR(1) process with an autoregressive coefficient of 0.5 (0.9) with two lags, the Cochrane measure equals 1.83 (2.74).
Lucas (1982) emphasized the analytical convenience of the assumption of perfect risk pooling in this class of models. Baxter and Crucini (1991) deviate from the standard settings in the literature by allowing incomplete financial markets to play a role in their two-country, one good model.
Note, that in a typical solution with perfect risk pooling, wealth effects do not play any role as the capital account dynamics is reduced to valuation effects.
The assumption of an exogenous production structure is primarily made for convenience given our focus on consumption smoothing. Endogenous production decisions are clearly a desirable extension of our model as changes in productive capacity across countries do not need to be solely linked to consumption decisions in a world with capital mobility. They also allow for a much richer dynamics in real exchange rates and wealth, which in that case is not only given by the net foreign asset position, but also by the domestic capital stock.
Arbitrary restrictions on the structure of financial markets is a general problem in general equilibrium models with incomplete financial markets (Geanakoplos (1990)). Allen and Gale (1994) show how the market structure can be endogenized by incorporating the production decision of financial intermediaries. An extension along this line is outside the scope of this study, however.
This does not imply that a stationary equilibrium will be reached from any initial condition.
For a theoretical exposition of these and related issues, see Giavazzi and Wyplosz (1984) and Krugman (1994).
King, Plosser, and Rebelo (1988), introduced this technique into the real business cycle literature.
In fact, it can be shown that the deviations of tradable consumption from the steady state value do not depend on the current net foreign asset position. It is clear that this result depends crucially on the assumption that we have abstracted from borrowing constraints or other imperfections in the derivation.
This is the case if the elasticity of the marginal utility from tradable goods consumption with respect to the marginal consumption from nontradables consumption, (1-α)(1-γ)/(α(1-γ) -1), is positive.
See Taylor and Uhlig (1992) for an overview of alternative solution techniques for multiperiod rational expectations models in the context of a neoclassical, closed-economy growth model. The parametrized expectations algorithm was chosen for its simplicity. Given the experience of den Haan (1994), and given that there is only one endogenous state variable, this algorithm can be expected to work quite well in this application.
Canova and Delias (1993) showed that results in their study of the trade balance in the international real business cycle model were very sensitive to the detrending method. In order to check the sensitivity of our results to the use of the HP filter with parameter 100, we reran the simulations with an HP filter with parameter 10. Baxter and King (1995) showed that this detrending method is very close to their proposed band-pass filter which we could not use due to the short sample period. The results change only very little using this filter. In addition, we aggregated the ROW tradables and nontradables output series using actual exchange rates rather than PPP values. Again, the results do not change qualitatively. Results from these two alterations are available from the authors.