Limited Participation in International Business Cycle Models: A Formal Evaluation
In this paper we study the role of limited asset market participation (LAMP) for international business cycles. We show that when limited participation is introduced into an otherwise standard model of international business cycles, the performance of the model improves significantly, especially in matching cross-country correlations. To perform formal evaluation of the models we develop a novel statistical procedure that adapts the test of Vuong (1989) to DSGE models and accounts for the possibility that models are misspecified. Based on this test we show that the improvements brought out by LAMP are statistically significant, leading a model with LAMP to outperform a representative agent model. Furthermore, when LAMP is introduced, a model with complete markets is found to do better than a model with no trade in financial assets ? a well-known favorite in the literature. Our results remain robust to the inclusion of investment specific technical change.
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