Productivity Shocks and Consumption Smoothing in the International Economy

We develop a two-country, dynamic general equilibrium model that links cross-country differences in net foreign asset and consumption dynamics to differences in discount factors and steady-state levels of productivity. We compare the results of the model to those of VARs for the G3 economies. We identify country-specific productivity shocks by assuming that productivity does not respond contemporaneously to other variables in these VARs. We identify global productivity shocks by estimating the VARs in common trend representation after testing for and imposing model-based, long-run cointegration restrictions. We then compare the model’s predictions for net foreign asset and consumption dynamics in response to productivity shocks with the estimated VAR impulse responses. We find that the two sources of heterogeneity we consider go some way toward reconciling the consumption smoothing hypothesis with the data and explaining variations in net foreign asset and consumption dynamics across countries. JEL Classification: F41, C33