Reexamination of Real Business Cycles in a Small Open Economy

Standard dynamic small open economy models have predicted a counterfactual perfectly positive correlation between output and hours worked over the business cycle. In addition, this class of models exhibits a weak internal propagation mechanism. To address these anomalies, this paper incorporates intertemporally non‐separable labor supply and variable capital utilization into the canonical Mendoza (1991) model with adjustment costs of net investment. Our analysis shows that a dynamic, technology shock–driven small open economy model with internal habit formation in labor hours and endogenous capital utilization is able to account for the main real business cycle regularities of Canada after 1981.