International business cycles and the relative price of investment goods

International business cycles and the relative price of investment goods

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Article ID: iaor201111965
Volume: 44
Issue: 2
Start Page Number: 580
End Page Number: 606
Publication Date: May 2011
Journal: Canadian Journal of Economics/Revue canadienne d'conomique
Authors: ,
Keywords: investment, time series: forecasting methods, simulation
Abstract:

Is the relative price of investment goods a good proxy for investment specific technology? We model this relative price in a flexible price international economy with two fundamental shocks, namely, the total factor productivity (TFP) shock and the investment‐specific technology (IST) shock. We show that the one‐to‐one correspondence between the IST shock and the relative price of investment goods breaks down in an international economy because of the short‐run correlation between the terms of trade and the relative price of investment goods. The data congruent negative correlation between the investment rate and the relative price of investment goods thus does not necessarily reflect decline in investment frictions (rise in IST), as suggested by many studies. A calibration experiment with the US data demonstrates that such an inverse relation between rate of investment and the relative price of investment goods basically reflects the positive effect of TFP on the terms of trade for a broad range of economies where the home bias in consumption exceeds investment and there is a sizable adjustment cost of investment.

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