Demand, Markups and the Business Cycle. Bayesian Estimation and Quantitative Analysis in Closed and Open Economies

We generalize the demand side of a Real Business Cycle model introducing non-homothetic preferences over differentiated final goods. Under monopolistic competition this generates variable markups that depend on the level of consumption. We estimate a flexible preference specification through Bayesian methods and obtain countercyclical markups. The associated closed-economy model magnifies the propagation of shocks (compared to perfect competition or fixed markups) through additional substitution effects on labor supply and consumption. In an open-economy framework, it also generates positive comovements of output, labor and investment and reduces consumption correlation between countries: in particular, a positive shock in the Home country reduces its markups and improves its terms of trade, which promotes consumption in the Home country but also production in the Foreign country to exploit the increased profitability of exports.