International Risk Cycles
This paper presents a two-country real business cycle model with two novel features: exogenous shocks to worldwide uncertainty, heterogeneous exposures to the world aggregate shock. The authors show that these two features lead to significant progress in tackling international finance puzzles. When world risk increases, investment decreases and a worldwide recession follows, even in the absence of technology shocks. Capital pulls out of the riskier country, which experiences the largest recession. Both stock markets tank and the high interest rate currency depreciates.