This chapter is structured in three parts. The first part outlines the methodological steps, involving both theoretical and empirical work, for assessing whether an observed allocation of resources across countries is efficient. The second part applies the methodology to the long-run allocation of capital and consumption in a large cross section of countries. We find that countries that grow faster in the long run also tend to save more both domestically and internationally. These facts suggest that either the long-run allocation of resources across countries is inefficient, or that there is a systematic relation between fast growth and preference for delayed consumption. The third part applies the methodology to the allocation of resources across developed countries at the business cycle frequency. Here we discuss how evidence on international quantity comovement, exchange rates, asset prices, and international portfolio holdings can be used to assess efficiency. Overall, quantities and portfolios appear consistent with efficiency, while evidence from prices is difficult to interpret using standard models. The welfare costs associated with an inefficient allocation of resources over the business cycle can be significant if shocks to relative country permanent income are large. In those cases partial financial liberalization can lower welfare.

Real business cycles are recurrent fluctuations in an economy’s incomes, products, and factor inputs—especially labor—that are due to nonmonetary sources. These sources include changes in technology, tax rates and government spending, tastes, government regulation, terms of trade, and energy prices. Most real business cycle (RBC) models are variants or extensions of a neoclassical growth model. One such prototype is introduced. It is then shown how RBC theorists, applying the methodology of Kydland and Prescott (Econometrica 1982), use theory to make predictions about actual time series. Extensions of the prototype model, current issues, and open questions are also discussed.

We find that in a sample of emerging economies business cycles are more volatile than in developed ones, real interest rates are countercyclical and lead the cycle, consumption is more volatile than output and net exports are strongly countercyclical. We present a model of a small open economy, where the real interest rate is decomposed in an international rate and a country risk component. Country risk is affected by fundamental shocks but, through the presence of working capital, also amplifies the effects of those shocks. The model generates business cycles consistent with Argentine data. Eliminating country risk lowers Argentine output volatility by 27% while stabilizing international rates lowers it by less than 3%.