Does the Number of Countries in an International Business Cycle Model Matter?

Abstract

Until the 1990s, standard models with two large open economies (i.e. the U.S. and Europe) provided plausible representations of the world economy. However, with the emergence of many countries such as China since then, this approach no longer seems reasonable. In line with this change to the global economic environment, there also have been changes in cross-country correlations: the output correlation between the U.S. and Europe has risen, and their consumption correlation has slightly fallen. Accordingly, this paper adds many countries to a standard model to show that doing so can capture the transition in the cross-country correlations. By analytical investigation, I first show that as the number of countries in a simple model increases, the output correlation rises and the consumption correlation falls. A quantitative analysis with a more general model also shows that when the model has more countries, it yields a higher output correlation and a smaller consumption correlation.