Complete vs. Incomplete Market (2)

Baxter, M. and M. J. Crucini. 1995. "Business Cycles and the Asset Structure of Foreign-Trade." International Economic Review

International correlation puzzles for consumption and output

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As discussed by Backus, Kehoe, and Kydland (1992) and Baxter and Crucini (1993), the complete markets economy does reasonably well in matching thewithin-country stylized facts concerning volatility and persistence of macro aggregates.  Much more problematic are the complete markets model's implications for cross-country correlations of output, consumption, investment, and labor input.  Specifically, this model has difficulty generating positive output comovement (and correspondingly positive comovement of investments and labor inputs across countries). Further, the model predicts a level of cross-country consumption correlationthat is much too high relative to the data.

Because individuals are subject to idiosyncratic (nation-specific) risk in the bond economy, in equilibrium this economy will display nation-specific fluctuations in consumption. Thus we expect that the international correlation between consumptionsshould be lower in the bond economy, and it is-but not much lower.

Similarly, we expect the absence of insurance against labor income risk in the bond economy to alter the response of labor input to productivity shocks. In the complete markets economy, the response to a positive productivity shock in one country generates an increase in labor input in the productive country, and a tendency for a decline in labor input in the relatively unproductive country. Because of the optimal insurance character of the complete markets equilibrium, workers in the productive country agree to "share" some of the additional output generated by the increase in productivity and labor input, in exchange for similar "sharing"when the other country receives a positive productivity shock. In the bond economy, individuals can only smooth consumption across time (by buying or selling bonds); they cannot smooth consumption across different "states of nature" because of the absence of contingent securities. This reduces the tendency for labor input to decline in the temporarily unproductive location.
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