Munich Personal RePEc ArchiveTheHighCross-CountryCorrelationsofPricesandInterestRatesEspen Henriksen and Finn Kydland and Roman SustekUniversityofOslo12. September2008Onlineathttp://mpra.ub.uni-muenchen.de/10963/MPRAPaperNo. 10963,posted8. October200810:49UTCTheHighCross-CountryCorrelationsofPricesandInterestRatesEspenHenriksen,FinnE.Kydland,andRomanSustekSeptember12,2008AbstractWedocumentthat,atbusinesscyclefrequencies,uctuationsinnominalvariables,suchasaggregate price levels and nominal interest rates, are substantially more synchronized acrosscountries than uctuations in real output. To the extent that domestic nominal variables aredeterminedbydomesticmonetarypolicy,andcentralbanksgenerallyattempttokeepthedomestic nominal environment stable, this might seem surprising. We ask if a parsimoniousinternational businesscyclemodel canaccountforthisaspectof cross-countryaggregateuctuations. It can. Due to spillovers of technology shocks across countries, expected futureresponses of national central banks to uctuations in domestic output and ination generatemovementsincurrentpricesandinterestratesthataresynchronizedacrosscountriesevenwhen output is not. Even modest spillovers produce cross-country correlations such as thoseinthedata.JELClassicationCodes: E31,E32,E43,F42.Keywords: Internationalbusinesscycles,prices,interestrates.WewouldliketothankJonathanHeathcote,NarayanaKocherlakota,JensSondergaard,theUCSantaBarbara macro lunch participants, and seminar participants at the Bank of Korea, Bank of England, Univer-sity of Oslo, Midwest Macro Meetings in Philadelphia, NASM in Pittsburgh, SED meetings in Boston, NordicSummerSymposiuminMacroeconomicsinSandbjerg, ESEMinMilan, andMMFconferenceatBirkbeckforcomments. Kjetil StoreslettenandEricYoungprovidedespeciallyhelpful commentsandsuggestions.HenriksenandSustekwouldalsoliketothanktheLaboratoryforAggregateEconomicsandFinanceatUCSantaBarbaraforitshospitalityduringtheirvisit. Theviewsinthispaperarethoseof theauthorsanddonot necessarilyreect thoseof theBankof Englandor theMonetaryPolicyCommittee. This paperpreviously circulated under the title The High Correlations of Prices and of Interest Rates across Nations.DepartmentofEconomics,UniversityofOslo;espen.henriksen@econ.uio.no.DepartmentofEconomics,UniversityofCaliforniaSantaBarbara;kydland@econ.ucsb.edu.MonetaryAssessmentandStrategyDivision,BankofEngland;roman.sustek@bankofengland.co.uk.1 IntroductionWedocumentcross-countrymovementsatbusinesscyclefrequenciesintwokeynominalvariables,theaggregatepricelevelandtheshort-termnominalinterestrate,andcomparethemwithcross-countrymovementsinoutput. Wendthattheuctuationsinthetwonominal variables are substantially more synchronized across countries than the uctuationsinoutput. Weaskif adynamicgeneral equilibriummodel canaccountforthisempiricalregularity.Our observation is based on a sample of the largest industrial economies.1Using businesscyclecomponents2of aggregate price levels, short-termnominal interest rates, andrealGDPobtainedwithaband-passlter, wendthattheuctuationsinthethreevariablesaresimilarintermsof theirvolatilityandpersistence, butmarkedlydierentintermsoftheir cross-countrycomovements. Inparticular, the cross-countrycorrelations of pricesandnominal interestratesaresubstantiallyhigherthanthoseof output: Fortheperiod1960.Q12006.Q4theaverage(acrosscountrypairs)bilateral correlationof pricelevelsis0.52, thatof short-termnominal interestrates0.57, whilethatof real GDPisonly0.25.Moreover, the bilateral correlations of the twonominal variables varysubstantiallylessacrosscountrypairsthanthoseofrealGDP.Thisempiricalregularityisbroadlyrobusttothe inclusion of other economies as the required data become available, the exclusion of theBrettonWoodsyears, andtosplittingthesampleintotwosubsamplesin1984, theyeargenerallyassociatedwiththestartof theso-calledGreatModerationaperiodoflowmacroeconomicvolatility,andlowandstableination.Our empirical workis relatedtoaliterature studyingthe degree of comovement ofmacroeconomic variables across countries. It has beenwell documentedthat real eco-nomicactivitytends tomovetogether across industrializedeconomies over thebusinesscycle (Backus,KehoeandKydland, 1992; Kose,OtrokandWhiteman, 2003). Recently,however, economists, aswell aspolicymakers, becameinterestedinthecross-countryco-1Inparticular,Australia,Canada,Germany,Japan,theUnitedKingdom,andtheUnitedStatesfortheperiod1960.Q12006.Q4. Inaddition,from1970.Q1oursampleincludesalsoAustriaandFrance.2Medium-termuctuationsinthedatawithperiodicityofapproximately8to32quarters.movement of ination (Besley, 2008; CiccarelliandMojon, 2005; MumtazandSurico, 2008;WangandWen, 2007). Anempirical contributionof thispaperliesindocumenting, inaunied way, comovements across countries of cyclical uctuations in both output and prices,aswellasinashort-termnominalinterestrate.3Totheextentthatatbusinesscyclefrequenciesdomesticnominalvariablesarelargelydeterminedbydomestic monetarypolicy, andcentral banks generallyattempt to keepthe domestic nominal environment stable, our empirical ndingmight seemsurprising.Althoughwewouldexpectsomepositivecross-countrycorrelationsofpricesandnominalinterest rates, due to, for instance, the cross-country comovement of output, it is not obviouswhyvariablesthatindividual central banksaremorelikelytobeabletocontrol atthesefrequencies co-move more strongly across countries than real economic activity. We view thisempirical regularity as a key aspect of international aggregate uctuations and believe thataccountingforitcanprovidevaluableinsightsintohownominal variablesaredeterminedin an international environment an issue that has recently received a lot of attention frompolicymakers.4For a part of our sample period the Bretton Woods years national monetary policieswere, tosomeextent, constrainedbygovernments obligationstomaintainxedexchangerates withthe dollar. It is well knownthat under xedexchange rates, the domesticeconomyisnotinsulatedfromnominal shocksthatoccurabroad.5AscontrollingfortheBretton Woods period does not aect our empirical nding, however, and our sample is notbiasedtowardscountriesparticipatingintheEuropeanMonetarySystem(EMS),itseemsthatthereareotherreasonsforthestrongcross-countrycomovementsofthetwonominalvariablesthanpastexchange-ratearrangements.A large literature argues that monetary policy of major central banks is reasonably well3WangandWen (2007) compare cross-country comovements of ination rates with cross-country comove-mentsofcyclical uctuationsinoutput. Theyndthatinationratesaremorestronglycorrelatedacrosscountriesthancyclicaluctuationsinoutput. Incontrast,wefocusoncyclicaluctuationsinbothoutputandprices.4See,forexample,Bean(2006),Bernanke(2007),Mishkin(2007),andSentance(2008).5Someresearchers(e.g., Eichengreen, 1996), however, arguethatduringthisperiodcentral bankswereable to retain a signicant degree of monetary autonomy by imposing various capital controls, and thus wereabletocontrolthedomesticnominalenvironment.2approximatedbytheso-calledTaylor rule aparsimonious feedbackrulewherebythecentral bank sets the short-term nominal interest rate in response to movements in domesticoutput andchanges inthedomesticpricelevel.6Thehighcross-countrycorrelations ofshort-termnominalinterestratescanthuspotentiallybeaccountedforbythehighcross-countrycorrelations of prices. But inequilibrium, pricesandnominal interest rates arejointly determined. How, then, do responses of national central banks to domestic economicconditions leadtosubstantiallystronger cross-countrycomovements of thetwonominalvariablesthanofoutput?Inthesecondpartof thepaper, weprovideaquantitative-theoretical accountof ourempirical nding. Asarststepitisnatural toaskifaparsimoniousinternational busi-nesscyclemodel,suchasthetwo-goodtwo-countrymodelofBackus,KehoeandKydland(1994), canhelpusunderstandthisfeatureof international businesscycles. Inordertomakethemodel suitableforourquestion, weaugmentitbyincludingnominal assetsinthehouseholdsbudgetconstraintsandineachcountryacentralbankwhich, inlinewiththeaboveliterature,followsaTaylorrule. Wendthat,toalargeextent,themodeldoesaccountforourempiricalnding. Whencalibratedtobeconsistentwithlong-runfeaturesof thedataandstandardvalues of theTaylor rule, themodel produces aslightlylowercross-country correlation of output and slightly higher cross-country correlations of the twonominalvariablesthantheaveragesofthoseobservedinthedata.Inorder tohighlight themechanismbehindthis result, weshowthat inarecursiveequilibrium theabsenceof arbitragebetween real andnominalassets,togetherwitha Tay-lorrule,impliesthatthecurrentpricelevelandnominalinterestratedependonexpectedfutureoutput andreal returns tocapital. Duetospilloversof technologyshocks acrosscountries,apersistentdomestictechnologyshockaectsfutureproductivityintheforeigneconomy, inadditiontocurrentandfutureproductivityinthedomesticeconomy. Thus,although currentoutput (determined in large part by the current level of technology) in the6See, among others, Taylor (1993) and Clarida,GalandGertler (2000) for the United States,Clarida,GalandGertler (1998) for most of the G7countries, andNelson(2000) for the UnitedKing-dom. Woodford(2003),chapter1,providesausefulsurvey. MoststudiesestimateTaylorrulesonlyforthepost-1979period,althoughsome,forexampleClaridaetal.(2000),Orphanides(2002),andTaylor(1999),provideestimatesalsoforthe1960sand1970s.3twoeconomiesmaybedierent,futureoutputandreturnstocapitalinthetwoeconomiesareexpectedtobesimilar, leadingtosimilarresponsesof current pricesandnominal in-terestrates. Thus,accordingtothemodel,uctuationsinnominalvariableswillbehighlysynchronized across countries even when national central banks focus squarely on stabilizingdomesticoutputandprices.Wendthatevenamodestdegreeof spillovers, intherangeof someof thesmallerestimates foundintheliterature, produces correlations suchas thoseinthedata. TheresultisrobustalsotoabroadrangeofparametervaluesoftheTaylorrule, aswellastoasimpleextensionthatallowsthemodel tobeconsistentwiththeobserveddynamicsofdomesticpricesandinterestratesinrelationtodomesticoutput. Interestingly, theresultsurvives when monetary policy reduces the volatility of the two nominal variables well belowtheiraveragevolatilityinthepostwarperiod. Thisisconsistentwithourempiricalndingthattheinternational nominal cycle issubstantiallymoresynchronizedacrosscountriesthantheinternationalrealcycleevenintheGreatModerationperiod.Theoutlineof therestof thepaperisasfollows. Section2documentstheempiricalregularity, Section3introduces themodel, Section4describes its calibration, Section5presentsndingsforabenchmarkexperiment,Section6conductssensitivityanalysis,andSection7concludes. Anappendixdescribesthedatasources.2 Propertiesofnominal businesscyclesOur empirical analysis is based on quarterly data series for real GDP, price levels measuredbytheconsumerpriceindex, andshort-termnominal interestrates, usuallyyieldson3-monthgovernment bills, for Australia, Canada, Germany, Japan, the UnitedKingdom,andtheUnitedStates, fortheperiod1960.Q1-2006.Q4. Inaddition, weincludeAustriaandFrancefrom1970.Q1. Forotherdevelopedeconomies, therequireddataareavailableonlyfromeither late1970s or early1980s. However, weprefer totradeothenumberofcountriesforseriesthatincludeboththerelativelystable1960s, aswell asthevolatile1970s. Furthermore, most of the economies for which the data are available from either late41970s or early 1980s are European economies that participated in the EMS. Including thosecountriesintooursamplewouldthereforemakethesamplebiasedtowardseconomiesthatoperatedunderaxed-exchange-rateregimeforasubstantialperiodoftime.All statisticsdiscussedinthissectionareforbusinesscyclecomponentsof thethreevariablesof interest obtainedwiththeChristianoandFitzgerald(2003) band-pass lter.Beforeapplyingthislter, theseriesforreal GDPandpricelevelsweretransformedbytakinglogs. Theiructuationscanthusbeexpressedaspercentagedeviationsfromtrend.2.1 International nominal businesscyclesIn order to provide a general sense of the dierent degrees of synchronization of the interna-tionalrealandnominalbusinesscycles,Figure1plotspercentagedeviationsfromtrendofrealGDPandpricelevelsforthecountriesinoursample. Weseefromthisgurethatal-though the uctuations in both variables tend to co-move across countries, the uctuationsinpricesaremoresynchronizedthanthoseinrealGDP.The stronger cross-countrycomovement of prices, as well as nominal interest rates,relativetothatofoutput, becomesclearlyapparentoncewecalculatethebilateral cross-countrycorrelationsforthesetwonominal variables(i.e., thecorrelationsof acountrysvariablewiththesamevariableof eachof theother countries) andcomparethemwiththose for real GDP. These correlations are containedinTables 1-3, for the six-countrysamplegoingbackto1960.Q1,andinTables4-6fortheeight-countrysample,whichgoesbackto1970.Q1.Inthesix-countrysample, themean(inthecross-section)bilateral correlationsofthenominal interestrateandthepricelevel are0.57and0.52, respectivelyabouttwicethemean bilateral correlation of real GDP, which is 0.27. In addition, the bilateral correlationsofthetwonominalvariablesaresubstantiallylessdispersedinthecross-sectionthanthoseof real GDP. The coecient of variation (i.e., the standard deviation divided by the mean) ofthebilateralcorrelationsofthenominalinterestrateandthepricelevelare0.22and0.28,respectively, whilethat of thebilateral correlations of real GDPis 0.89. Thesendingsholdbroadlyalsointheeight-countrysample,wherethemeanbilateralcorrelationsofthe5nominalinterestrateandthepricelevelareboth0.59,whilethatofrealGDPisonly0.43(the coecients of variation are around 0.2 for the two nominal variables, and slightly above0.5forrealGDP).Eventhoughthetwonominal variablesdiermarkedlyfromoutputintermsof theircross-countrycomovements,theyarecomparablyvolatileandpersistent. Forexample,themean standard deviation of output in the sample of the six countries is 1.39, while the meanstandarddeviationofthepricelevelis1.28andthatofthenominalinterestrateis1.317;and the mean rst-order autocorrelation coecient of output is 0.92, while that of the pricelevelis0.94andthatofthenominalinterestrateis0.91.Figure 2 provides an additional representation of the stronger cross-country comovementof the two nominal variables, relative to that of output. It plots the bilateral correlations ofthepricelevelandthenominalinterestrateagainstthebilateralcorrelationsofoutputfortheeight-countrysample. Aswecansee, mostof thepointslieabovethe45-degreeline,meaning that for most country pairs, the bilateral correlations of the two nominal variablesarehigherthanthoseofrealGDP.In order to check that the high cross-country correlations of prices and nominal interestratesarenotdrivenbyastrongcomovementonlyintheperiodduringwhichthecountriesinoursampleoperatedundertheBrettonWoodsagreement, wereportinTables1-6alsothe mean bilateral correlations and coecients of variation for the period 1974.Q1-2006.Q4,whichexcludestheBrettonWoodsyears. Aswecansee, forall threevariablesthetwosummarystatistics are little aectedbyexcludingthe BrettonWoods periodfromoursample.Besidesxedexchangerates, global commoditypriceshockscouldbeanothersourceof thestrongcross-countrycomovementsof pricesandnominal interestratesobservedinthedata. VisualinspectionofFigure1,however,showsastrikingcomovementofthepricelevelsinallpostwarbusinesscycles,notjustthetwocyclescommonlyassociatedwiththeoilpriceshocksof1973and1979thetwolargestcommoditypriceshocksinthepost-warperiod. Inordertocheckthismoreformally, wesplitthesampleintotwosubsamplesin7Thestandarddeviationofthenominalinterestrateisfoructuationsmeasuredinpercentagepoints.61984, theyear broadlyassociatedwiththestart of theGreat Moderation. Duringthisperiod of relative output and ination stability, the world economy did not experience largecommodity price shocks, such as those of the 1970s. We nd that although the mean cross-countrycorrelations of all threevariables declinedafter 1984, thoseof thetwonominalvariables are still substantially higher than that of output (see Tables 1-6). For example, intheeight-countrysample, thepost-1984meanbilateralcorrelationofthenominalinterestrateis0.46,thatofthepricelevelsis0.45,whilethatofrealGDPisonly0.19.2.2 Domesticnominal businesscyclesKydlandandPrescott (1990) have pointed out that a key characteristic of the nominal sideof the U.S. business cycle is the countercyclical behavior of prices i.e. the aggregatepricelevel isnegativelycorrelatedwithoutputoverthebusinesscycle. WendthatthischaracteristicofthecyclicalbehaviorofpricesisnotspecictotheU.S.economy. Figure3plotsthecorrelationof acountryspricelevel inperiodt + j withitsoutputinperiodt, forj{5, 4, 3, 2, 1, 0, 1, 2, 3, 4, 5}. Weseethatforalleconomiesinoursample,the contemporaneous correlation (i.e., that for j= 0) is negative. Notice also that the pricelevelinalleighteconomiesexhibitsaphaseshiftinthedirectionofnegativelyleadingthecycle; i.e., the price level is more negatively correlated with future output than with currentoutput.8In Figure 4 we extend this analysis to the nominal interest rate. We see that the nominalinterestrateingeneral issomewhatpositivelycorrelatedwithoutputcontemporaneously,but is strongly negatively correlated with future output, and positively correlated with pastoutput. Althoughthisdynamicsof thenominal interestrateiswell knownfortheU.S.economy(e.g.,KingandWatson,1996),asinthecaseofthepricelevel,itisstrikingthatweobservethesameempiricalregularityalsoinotherdevelopedeconomies. InSubsection6.3weinvestigate,therefore,iftheparsimoniousinternationalbusinesscyclemodelcanbe8WangandWen(2007) ndthat thelead-lagpatternof actual inationrates, as opposedtocyclicalcomponents of uctuations inprices, withoutput is alsoverysimilar across countries. GalandGertler(1999) were among rst to point out a systematic lead-lag pattern between output and ination. In addition,denHaanandSumner(2004),usingVARanalysis,ndasimilardynamicsofpricesacrossG7countries.7consistent with both, the high cross-country correlations of prices and nominal interest rates,aswell aswiththeobservedlead-lagpatternsof thesevariableswithrespecttodomesticoutput.3 Themodel economyAworldeconomyconsistsoftwocountries,denoted1and2,whicharepopulatedbyequalmeasuresof identical, innitelylivedconsumers. Producersineachcountryusecountry-speciccapital andlabortoproduceasinglegood, whichwerefertoasalocalgood.Production in each country is subject to technology shocks, which aect the productivity ofcapitalandlabor. Theseshocksaretheonlysourcesofuncertaintyintheworldeconomy.The good produced in country 1 is labelled by a, while that produced in country 2 is labelledby b. These are the only traded goods in the world economy. Within each country,goods aand b are combined to form a good that can be used for local consumption and investment,and which we refer to as an expenditure good. In order to purchase the expenditure goodforconsumptionpurposes, consumershavetoincuratimecost, whichdependspositivelyontheamountof purchasesmadeandnegativelyontheamountof real moneybalancesheld. Inadditiontodomesticmoneybalances,consumersineachcountrycanaccumulatecapital, aninternationallytradedbond, andadomesticallytradedbond, whosenominalrateofreturnincontrolledbyadomesticcentralbank.3.1 PreferencesPreferences of the representativeconsumer incountryi arecharacterizedbythe utilityfunctionE0

t=0tU (cit, 1 nit sit) , (1)whereU (c, 1 n s)=_c(1 n s)1_1/ (1 ), with0