Pricing-to-market and business cycle synchronization

There is substantial evidence that countries or regions with stronger trade linkages tend to have business cycles which are more synchronized. However, the standard international business cycle framework cannot replicate this finding. In this paper we study a multiple- country model of international trade with imperfect competition and variable markups and embed it into a real business cycle framework by including aggregate technology shocks and allowing for variable labor supply. The model is successful at replicating the empirical relation between trade and business cycle synchronization. High trade costs increase the real exchange rate volatility because firms choose to price-to-market and this volatility decouples countries' business cycle fluctuations. We find empirical evidence supporting this mechanism.