Wednesday, September 21, 2011

INSEAD Working Paper 2011/93/EPS

Countries that trade more with each other tend to have more correlated business cycles. Yet, traditional international business cycle models predict a much weaker connection between trade and output comovement. We propose that international technology diffusion through trade in varieties may be driving this comovement, by increasing the correlation of TFP. Our hypothesis is that business cycles should be more correlated for countries that trade a wider variety of goods rather than larger quantities of already traded goods. We find empirical support for this hypothesis. When we decompose trade into its extensive and intensive margins, we find that the extensive margin explains most of the trade-output and trade-TFP comovement. This finding is striking given that the extensive margin only accounts for one third of total trade. We then develop a 3-country model of innovation and adoption, in which TFP correlation increases with trade in varieties, and show with a numerical exercise that the proposed mechanism increases business cycle synchronization with respect to traditional models.