Financial development and innovation: A DSGE comparison of Chinese and US business cycles

This paper investigates the contrasting business cycle characteristics of China and the US, specifically in terms of economic activity and total factor productivity. To help explain the differing profiles for these two variables for both countries, we build and estimate a DSGE model with extended financial markets and endogenous technology creation to identify key structural parameters, comparing the decomposition of the shock processes in our analysis. We reveal stark differences in the contributing factors of business cycle fluctuations for both countries, and demonstrate the importance of the stock market for economic recovery after a sizable and persistent financial shock. Macroeconomic intervention in China works well but is unable to smooth total factor productivity (TFP) due to the presence of multiple shocks transmitted through the endogenous technology creation channel. Whilst the US achieves a similar profile for economic activity with less volatility in TFP, it also contends with additional risks, fed in by the existence of the stock market. The stock market allows firms to hedge finance during periods of financial instability, though this is not cost free.