Working Paper No. 05-02

Closing International Real Business Cycle Models with Restricted Financial Markets
Martin Boileau and Michel Normandin
March 2005


Several authors argue that international real business cycle (IRBC) models with incomplete financial markets offer a good explanation of the ranking of cross-country correlations. Unfortunately, this conclusion is suspect, because it is commonly based on an analysis of the near steady state dynamics using a linearized system of equations. The baseline IRBC model with incomplete financial markets does not possess a unique deterministic steady state and, as a result, its linear system of difference equations is not stationary. We show that the explanation of the ranking of cross-country correlations is robust to modifications that ensure a unique steady state and a stationary system of linear difference equations. We find, however, that the modifications affect the quantitative predictions regarding key macroeconomic variables.

JEL classification: F32; G15
Keywords: incomplete markets; stationarity, cross-country correlations; wealth effects