Endogenous fluctuations and international business cycles

We introduce equilibrium indeterminacy into a two-country incomplete asset model with imperfect competition to analyze the role of self-fulfilling expectations or beliefs in explaining international business cycles. We find that, when self-fulfilling beliefs are correlated with technology shocks, the model can account for the countercyclical behaviour observed for the terms of trade and real net exports while simultaneously generating higher volatilities relative to output, as in the data. The choice of the labour-supply elasticity is shown to be critical for generating a negative correlation between the real exchange rate and relative consumption, thereby resolving the Backus–Smith puzzle.