International propagation of technology shocks

Understanding the contributions that real shocks make to explaining business cycle fluctuations has long been an important part of macroeconomic research. An implicit assumption in much of the literature is that these shocks originate domestically, whether the method used to disentangle technology innovations is the Solow residual or the real/nominal decomposition of Blanchard and Quah or other identifying assumptions using sign restrictions. However, with increasing integration in world trade and capital flows (Grossman and Helpman, 1992) and greater emphasis in macroeconomic theory on the integration of markets, the importance of trade and the international spread of technological innovations, we need an approach that allows us to tie down different technological innovations to particular countries. This paper provides a way of doing this by decomposing technological progress at the sectoral level around the world into technology that originates domestically and technology that comes from abroad. A crucial assumption, following much of the theory in international trade is that an important carrier for the dissemination of technological innovations is international trade. A technological improvement in the USA makes exports to other countries more competitive, and this in turn encourages the local adoption of the innovation. Product innovations in this way are transmitted through trade in differentiated intermediate goods (Keller, 2002).

We decompose real and nominal shocks at the sectoral level in each economy into those which are sector-specific shocks which come from other domestic sectors as well as from sectors in other countries. We capture these inter-sectoral and international linkages through an input-output matrix for the world economy. The modelling of each sector uses the approach of Blanchard and Quah (1989), Shapiro and Watson (1988) and Gali (1999) by having labour productivity in the i^th sector affected only by real shocks in the long run that are specific to the i^th sector. However, we augment this approach by having labour productivity in the i^th sector affected also by real shocks in other sectors (domestic and interntional), weighted by the share of intermediate use of other sectors in the production of the i^th sector (Holly and Petrella, 2012).