Substitution Elasticities and Investment Dynamics in Two-Country Business Cycle Models

Two-country applications of equilibrium business cycle methodology have succeeded in matching some key features of international fluctuations. However, discrepancies between theory and data remain. This paper identifies an anomaly related to a basic property of typical models: The prediction of countercyclical net exports is fundamentally related to a counterfactual implication for negative cross-country investment correlations. The introduction of investment adjustment costs can induce positive investment comovement; however, this has the side-effect of reversing the cyclical behavior of net exports. The calibration of a low elasticity of substitution between domestic goods and imports is shown to be a more robust specification with regard to this and other puzzles that have arisen in the international business cycle literature.