Backus, Kehoe, and Kydland (1992), Baxter and Crucini (1995), and Stockman and Tesar (1995) find two major discrepancies between standard international business cycle models with complete markets and the data: In the models, cross-country correlations are much higher for consumption than for output, while in the data the opposite is true; and cross-country correlations of employment and investment are negative, while in the data they are positive. This paper introduces a friction into a standard model that helps resolve these anomalies. The friction is that international loans are imperfectly enforceable; any country can renege on its debts and suffer the consequences for future borrowing. To solve for equilibrium in this economy with endogenous incomplete markets, the methods of Marcet and Marimon (1999) are extended. Incorporating the friction helps resolve the anomalies more than does exogenously restricting the assets that can be traded.

We analyze the effects of money injections on interest rates and exchange rates when agents must pay a Baumol‐Tobin‐style fixed cost to exchange bonds and money. Asset markets are endogenously segmented because this fixed cost leads agents to trade bonds and money infrequently. When the government injects money through an open market operation, only those agents that are currently trading absorb these injections. Through their impact on these agents’ consumption, these money injections affect real interest rates and real exchange rates. The model generates the observed negative relation between expected inflation and real interest rates as well as persistent liquidity effects in interest rates and volatile and persistent exchange rates.

The central puzzle in international business cycles is that fluctuations in real exchange rates are volatile and persistent. We quantify the popular story for real exchange rate fluctuations: they are generated by monetary shocks interacting with sticky goods prices. If prices are held fixed for at least one year, risk aversion is high, and preferences are separable in leisure, then real exchange rates generated by the model are as volatile as in the data and quite persistent, but less so than in the data. The main discrepancy between the model and the data, the consumption—real exchange rate anomaly, is that the model generates a high correlation between real exchange rates and the ratio of consumption across countries, while the data show no clear pattern between these variables.

Bank of Minneapolis and University of Minnesota. We thank the NSF for financial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. The Great Depression is not yet well understood. Economists have offered many theories for both the massive decline and the slow recovery of output during 1929—39, but no consensus has formed on the main forces behind this major economic event. Here we describe and demonstrate a simple methodology for determining which types of theories are the most promising. Several prominent theories blame the Great Depression on frictions in labor and capital markets. The sticky wage theory is that wage stickiness together with a monetary contraction produces a downturn in output. (See Michael Bordo, Christopher Erceg, and Charles Evans 2001.) The cartelization theory is that an increase in cartelization and unionization leads to a slow recovery. (See Harold Cole and Lee Ohanian 2001.) The investment friction theory is that monetary contractions increase frictions in capital markets that produce investment-driven downturns in output.

Policy-Driven Productivity in Chile and Mexico in the 1980's and 1990's by Raphael Bergoeing, Patrick J. Kehoe, Timothy J. Kehoe and Raimundo Soto. Published in volume 92, issue 2, pages 16-21 of American Economic Review, May 2002