Preference shocks, international frictions, and international business cycles

- This paper incorporates preference shocks into a standard two-country dynamic stochastic general equilibrium model in which there exist international frictions, such as costs of transportation and restrictions to international asset trade.
- Preference shocks can solve the consumption correlation puzzle and the consumption-labor volatility puzzle. But the terms-of-trade puzzle is still a puzzle.
- The presence or absence of international frictions plays a limited role in solving the puzzles.

Replicating the degree of cross-country comovements of macroeconomic aggregates, dynamics of prices and quantities of international trade, and the behavior of consumption and labor remains an important challenge in international business cycle literature. This paper incorporates preference shocks into a standard two-country model in which there exist international frictions, such as costs of transportation and restrictions to international asset trade. Country-specific preference shocks that generate fluctuations in each country's consumption and labor solve the puzzles, except for the discrepancy between theory and data regarding international trade variables. The presence or absence of international frictions plays a limited role in solving the puzzles.