Fixed Costs of Capital Adjustment in a Two Country Real Business Cycle Model

The present paper analyzes the role of non-convex adjustment costs to capital in a stylized two country model of real business cycles. In contrast to the closed economy case, we find fixed adjustment costs to have a significant influence on investment decisions for each of the countries just as for the aggregated world economy. Like convex costs, fixed adjustment costs substantially limit capital re-allocation across countries. Because of this, they drive up the correlation of domestic investment and domestic saving, increase the correlation of output between countries, and decrease the variability of the trade balance. All this brings the model more in line with observed data. For the aggregated world economy, non-convex adjustment costs limit the variability of investment compared to the no-cost case, but the effect on the world economy is far less pronounced than on the individual economies.