Demand Shocks and Open Economy Puzzles

The paper explores to what extent demand shocks can solve the open economy puz- zles. To this purpose, we pose a shopping model structure a la Bai, R Ì Ä±os-Rull, and Storesletten (2011) on top of an otherwise standard two-country international real busi- ness cycle model. Shopping for goods take effort, which prevents perfect matching between potential customers and producers. Larger demand in a country increases its consumption for both home and foreign goods. Real exchange rate and terms of trade depreciate in response to the larger demand. Larger demand also induces more shop- ping and so higher output and TFP. Thus, demand shock under our shopping model generates countercyclical terms of trade and solves the Backus-Smith puzzle.