Søren Hove Ravn (University of Copenhagen) - The Transmission of Foreign Demand Shocks

Research Seminar - Søren Hove Ravn (University of Copenhagen) - The Transmission of Foreign Demand Shocks

Co-authors: Jeppe Druedahl (University of Copenhagen), Laura Sunder-Plassmann (University of Copenhagen), Jacob Marott Sundram (University of Copenhagen) and Nicolai Waldstrøm (University of Copenhagen)

Abstract:

Introducing heterogeneous households into a New Keynesian model of a small open economy enables the model to fit a set of stylized empirical facts about the transmission of foreign demand shocks. In the absence of a strong labor income effect on consumption, the model counterfactually implies that domestic consumption decreases as the central bank raises the interest rate to curb domestic inflation. With plausible marginal propensities to consume, the model instead produces the observed increase in domestic consumption of both tradeable and non-tradeable goods. This implies that foreign demand shocks are more important for international business-cycle co-movement than predicted by existing models. Our findings also have implications for stabilization policies: While monetary policy is well-suited to counteract foreign demand shocks, traditional fiscal policies are inadequate, as they do not provide sufficient stimulus to the tradeable sector. This poses a particular challenge for countries with a fixed exchange rate or in a monetary union.

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