International information flows, sentiments, and cross-country business cycle fluctuations

Business cycles are strongly correlated between countries. One possible explanation (beyond traditional economic linkages like trade or finance) is that consumer or business sentiments spread over borders and affect cyclical fluctuations in various countries. We first lend empirical support to this concept by showing that sentiments travel fast between countries, most probably directly via information flows. Then we embed this idea into a structural two-economy new Keynesian framework where noisy information available internationally can generate cyclical fluctuations (comovement of GDP, consumption, investments, and inflation) in both countries. Estimation with US and Canadian data reveals a significant role of US noise shocks in generating common fluctuations. They explain 20%-40% of consumption variance in the US and Canada and raise the correlation between these variables by up to unity in periods of sentiment breakdowns. We also show that our estimated noise shock can be interpreted as a sentiment shock.