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The international business cycle as intertemporal coordination failure

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Abstract

Where investments are irreversible and the future is uncertain, people in two countries can make investment decisions that turn out to be mutually inconsistent. I argue that this intertemporal coordination failure explains international business cycles in a two-currency-area setting with a floating foreign exchange rate. The sequence of events starts with an expansionary domestic monetary shock, which decreases the domestic real interest rate. Facing low transactions costs, people spend the new money relatively early in the foreign exchange market and in the foreign market for loanable funds. Domestic monetary expansion thereby changes the relative prices of domestic and foreign goods and also of goods of earlier and later stages of production. The relative price changes lead to intertemporal and international coordination failures once the monetary expansion ends and relative prices change. Domestic monetary policy thereby causes the comovement across different currency areas we observe of business cycles.

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Notes

  1. Trade share is the quantity of imports and exports of a given good during a given period divided by the imports and exports of all goods traded during that period.

  2. The same idea is often expressed in nominal terms in the following form: IRD=IRA*E[ER]/ER, where IR stands for nominal interest rate and ER for nominal exchange rate expressed as $D/$A, and E[x] represents expectation of variable x in the corresponding period in the future. Assuming that PD and PA represent price levels in D and A respectively, one can express that IRD=RIRD*(E[PD]/PD) and IRA=RIRA*(E[PA]/PA). It is also the case that ER=RER* PD/PA and E[ER]= E[RER]* E[PD]/E[PA]. After substitution into IRD=IRA*E[ER]/ER, one gets the following:

    RIRD*(E[PD]/PD)= RIRA*(E[PA]/PA)* (E[RER]* E[PD]/E[PA])/( RER* PD/PA).

    After rearrangement:

    RIRD= RIRA* E[RER]/RER*(PD/E[PD])* (E[PA]/PA)*(E[PD]/E[PA])*(PA/PD).

    And this is identical to the expression RIRD=RIRA*E[RER]/RER.

  3. The previous conclusion about the procyclical character of real imports and real exports in country D depends on an implicit assumption. While the expansionary monetary policy in country D might tend to increase the demand for imports through changes in the real interest rate, it also has an opposite tendency through the depreciated foreign exchange rate. The depreciation of $D makes imports more expensive and gives people an incentive to import less. Imports of country D therefore increase only if the effect of changes in the real interest rate is stronger than the counteracting effect of the foreign exchange rate.

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Acknowledgments

I would like to thank to Peter Boettke, Anthony Carilli, Harry David, Steven Horwitz, Sanford Ikeda, Paul Lewis, Nandakumar Rajagopalan, Shruti Rajagopalan, Mario Rizzo, Richard Wagner, Lawrence White, participants of Colloquium on Market Institutions and Economic Processes at NYU, and participants of the Graduate Student Paper Workshop at GMU for valuable comments on and suggestions to the earlier drafts of this paper. I gratefully acknowledge the financial help that I received from Bradley Foundation, Center for the History of Political Economy at Duke University, Earhart Foundation, Institute for Humane Studies, and Mercatus Center while working on this project. I am responsible for all errors.

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Bilo, S. The international business cycle as intertemporal coordination failure. Rev Austrian Econ 31, 27–49 (2018). https://doi.org/10.1007/s11138-016-0366-8

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