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Federal Reserve Bank of St. Louis
Working Papers
The Trade Comovement Puzzle and the Margins of International Trade
Wei Liao
Ana Maria Santacreu
Abstract

Countries that trade more with each other tend to have more correlated business cycles. Yet, traditional international business cycle models predict a much weaker link between trade and business cycle comovement. We propose that fluctuations in the number of varieties embedded in trade flows may drive the observed comovement by increasing the correlation among trading partners’ total factor productivity (TFP). Our hypothesis is that business cycles should be more correlated between countries that trade a wider variety of goods. We find empirical support for this hypothesis. After decomposing trade into its extensive and intensive margins, we find that the extensive margin explains most of the trade–TFP and trade–output comovement. This result is striking because the extensive margin accounts for only a fourth of the variability in total trade. We then develop a two-country model with heterogeneous firms, endogenous entry, and fixed export costs, in which TFP correlation increases with trade in varieties. A numerical exercise shows that our proposed mechanism increases business cycle synchronization compared with the levels predicted by traditional models.


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Wei Liao & Ana Maria Santacreu, The Trade Comovement Puzzle and the Margins of International Trade, Federal Reserve Bank of St. Louis, Working Papers 2014-43, 14 Nov 2014.
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Keywords: international business cycle comovement; TFP; extensive margin of trade.
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