Investment Frictions and the Relative Price of Investment Goods in an Open Economy Model

Is the relative price of investment goods a good proxy for investment frictions? We analyze investment frictions in an open economy, flexible price, two-country model and show that when the relative price of investment goods is endogenously determined in such a model, the relative price of investment can actually rise in response to a reduction in investment frictions. Only when the model is driven by TFP shocks do we observe a data congruent negative correlation between investment and the relative price of investment goods.