In this paper, I propose a two-country, dynamic, stochastic, general equilibrium (DSGE) model with endogenous tradability, product differentiation, variously determined physical capital, and an elastic labor supply to explore the propagation of business cycles across countries. I show that the model successfully addresses international relative price dynamics (its appreciation with positive home productivity shock, called the ‘Harrod-Balassa-Samuelson Effect’) through the entry of producers and their cut-off productivities of exporting. The use of endogenous physical capital in the model induces a more realistic framework since the simulated model is compared to the U.S. investment data that covers spending on capital equipment, structures and inventories for producers’ entry and exit dynamics. Building the model with endogenous capital and employment reduces the volatility of investment compared to conventional international real business cycle (IRBC) models. The model also accounts for several features of the data, such as the volatility of aggregate variables and their correlations with GDP.
In this paper, I examine the effects of adding non-traded output sector and trade in intermediate goods sector, and their impact on the 'Backus-Smith' (BS) puzzle and the features of the non-traded output. Conventional IRBC models show that the real exchange rate and the terms of trade is positively correlated to the relative consumption movement between the home and foreign economies when there is a total factor productivity shock due to efficient risk sharing, while the correlation in the data is negative. I develop a two-country, dynamic, stochastic, general equilibrium (DSGE) model with staggered price setting in non-traded output sector and international trade flow in intermediate goods sector due to product differentiation in a high asset market frictions situation. When the world economy has positive country-specific productivity shock, the benchmark model successfully provide the explanations of the BS puzzle and is able to match features of the U.S. non-traded output data. The dynamic responses to productivity shock suggest that integrating product differentiation is necessary to generate a more volatile and counter-cyclical non-traded output.