Government Spending, Distortionary Taxation and the International Transmission of Business Cycles

Abstract

We study the international transmission of aggregate TFP shocks by introducing demand-side shocks to government spending into an otherwise standard DSGE two-country, two-good model. In the model, the substitutability in consumption between private and public goods works to limit international risk sharing. Further, the distortive taxation used to finance the provision of public goods works to increase the correlation of employment, investment, and output across countries relative to standard models that lack this friction. In the quantitative analysis, we can bring the predictions of the theory closer to the observed properties of the data on the comovement of macroeconomic variables between the United States and other OECD countries. We are also able to provide a potential explanation to some of the puzzles in the international RBC literature, as identified by Backus, Kehoe, and Kydland (1992). The topic we study is fundamentally relevant and timely at a time when the crisis in the United States has spread to several other countries in the developed world, forcing governments to engage in active fiscal policy to help their economies in recession.