The model is similar to the IRBC models of gross trade like that of Boileau (1999), Erceg, Guerrieria, and Gust (2008), and Engel and Wang (2011) in that the traded sector is more volatile than the nontraded sector.
The modeling choice does not lose any significant features for the purposes of examining relative volatilities compared to IRBC models but gains tractability.
To see this, I expanded the model with the standard assumptions of the IRBC model.
While this extension is very similar to other IRBC models with VS trade, it is only one possible way of adding capital to the model.
In the standard IRBC model with no spillovers, when productivity increases at home, home households feel richer and output, consumption, and investment increase, while labor rises because of the upsurge in marginal productivity.
An important problem of IRBC models is that the co-movement between the real exchange rates and the ratio of consumptions does not match the one observed in the data (Backus and Smith, 1993).
Hence, we build a two-country, two-good model that we calibrate using standard parameters of the IRBC literature and estimated parameters of a vector error correction model (VECM) using TFP processes for the U.
In this section, we present a standard two-country, two-good IRBC model similar to the one described in Heathcote and Perri (2002).
As mentioned above, we depart from the standard assumption in the IRBC literature and consider processes for both log A ([s.
In the IRBC literature, it is typically assumed that the coefficients driving TFP processes are symmetric across countries.
In the typical IRBC model, there are two forces driving relative volatility of the real exchange rate with respect to output.