Working paper 730
In this paper I investigate, numerically, the co-movement puzzle by testing the ability of borrowing and lending constraints to counter the opposite movement of durable and non-durable goods in response to foreign monetary policy and international bond shocks. I do this by simulating a small open economy sticky price model calibrated to the South African economy over the period 1990Q012014Q04. I show that introducing borrowing and lending constraints into a small open economy sticky price model, in the face of foreign monetary policy tightening and an international bond shock, partially solves the co-movement puzzle. This is because the shadow value of durable goods reduces the incentive to accumulate durables for collateral because foreign lenders are less ecient than domestic lenders at recovering loans. In the case of sticky durables and sticky non-durables, the sticky price model mimics a fall in the relative price of durable goods observed in the data. Thus, nancial frictions such as borrowing and lending constraints make it possible to reconcile the sticky price model with the data.