Multiple Stages of Processing and the Quantity Anomaly in International Business Cycle Models

By Kevin X.D. Huang and Zheng Liu
June 2004 
RWP 04-05
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

      We construct a two-country DSGE model with multiple stages of processing and local currency staggered price-setting to study cross-country quantity correlations driven by monetary shocks. The model embodies a mechanism that propagates a monetary surprise in the home country to lower the foreign price level while restraining the home price level from rising too quickly; and, it does so through reducing material costs in terms of the foreign currency unit while dampening the upward movements in the costs in terms of the home currency unit, both in absolute terms and relative to the costs of primary factors. We show that, through this mechanism and a resulting factor substitution effect, the model is able to generate significant cross-country quantity correlations, with correlations in consumption considerably lower than correlations in output, as in the data.

Keywords: Stages of processing; Monopolistic competition; Local currency pricing; Welfare

JEL Codes: E32, F31, F41

Kevin Huang is a senior economist at the Federal Reserve Bank of Kansas City. Zheng Liu is an assistant professor in the Department of Economics at Emory University. The authors are grateful to Olivier Blanchard, Henning Bohn, V.V. Chari, Todd Clark, Rusell Cooper, Peter Ireland, Robert King, Nobuhiro Kiyotaki, Narayana Kocherlakota, Sylvain Leduc, Lee Ohanian, Alain Paquet, Louis Phaneuf, Cedric Tille, Kei-Mu Yi, Christian Zimmermann, and seminar participants at Boston University,Clark University, CREFE, Emory University, George Washington University, Tufts University, the University of California at Santa Barbara, Utah State University, the European Central Bank, the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Kansas City, the Federal Reserve Bank of Minneapolis, the 2000 Midwest Macroeconomics Conference, the 2000 World Congress of the Econometric Society, the 2000 Theory and Method in Macroeconomics Conference in Paris, the 2002 Annual Meeting of the Society for Economic Dynamics, the 2002 European Economic Association Annual Congress, the 2002 Federal Reserve System Committee Meeting on International Economics, and the 2003 Missouri Economic Conference for helpful comments.   The views expressed herein are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Huang email:  kevin.huang@kc.frb.org
Liu email:  zliu5@emory.edu

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