Explaining International Business Cycle Synchronization: Recursive Preferences and the Terms of Trade Channel

The business cycles of advanced economies are synchronized. Standard macro models
fail to explain that fact. This paper presents a simple model of a two-country, two-tradedgood,
complete-financial-markets world in which country-specific productivity shocks
generate business cycles that are highly correlated internationally. The model assumes
recursive intertemporal preferences (Epstein-Zin-Weil), and a muted response of labor
hours to household wealth changes (due to Greenwood-Hercowitz-Huffman period utility
and demand-determined employment under rigid wages). Recursive intertemporal
preferences magnify the terms of trade response to country-specific shocks. Hence, a
productivity (and GDP) increase in a given country triggers a strong improvement of the
foreign country’s terms of trade, which raises foreign labor demand. With a muted labor
wealth effect, foreign labor and GDP rise, i.e. domestic and foreign real activity
commove positively.