Explaining International Comovements of Output and Asset Returns : The Role of Money and Nominal Rigidities

Output and asset returns are highly positively correlated across the U.S. and the remaining major industrialized countries. Standard business cycle models that assume flexible prices and wages, in the Real Business Cycle (RBC) tradition, have great difficulties explaining this fact. This paper presents a dynamic-optimizing stochastic general equilibrium model of a two-country world with sticky nominal prices and wages. In RBC models, money supply shocks have a negligible effect on real variables. This changes when nominal rigidities are assumed. The nominal rigidities model here predicts that an exogenous money supply increase, in a given country, induces a sizable rise in that country's output, consumption and investment, a fall in its interest rate, as well as a nominal and real depreciation of its currency. Foreign output, consumption and investment are likewise predicted to rise. Nominal rigidities influence also the response of the economy to productivity shocks: in the nominal rigidities structure here, these shocks induce output responses that are much more strongly positively correlated across countries, than predicted responses to productivity shocks generated by standard RBC models. The structure here generates thus cross-country correlations of output (and of aset returns) that are markedly higher, and hence closer to the data, than the correlations that obtain under flexible prices and wages. monetary policy, asset returns