www.elsevier.com/locate/econbase Trade integration and risk sharing

What are the e+ects of increased trade in goods and services on the trade balance? We study the e+ects of reducing transport costs in a Ricardian model with complete asset markets and.nd that this increases the volatility of the trade balance. This result applies regardless of whether supply or demand shocks are the main source of economic /uctuations. Both type of shocks generate /uctuations in the trade balance that are in part moderated by stabilizing movements in the terms of trade. Trade integration dampens these terms of trade movements and, for a given distribution of shocks, ampli.es /uctuations in the trade balance. To overturn this result, one must assume that either trade integration is su2ciently biased towards goods with strong comparative advantage and=or risk aversion is su2ciently extreme. We calibrate the model to U.S. data and.nd that, for reasonable parameter values, increased trade in services could double the volatility of the trade balance. c © 2002 Elsevier Science B.V. All rights reserved. In the last 30 years, the volume of trade among industrial countries has more than tripled. During this same period, trade imbalances among these countries have grown larger and more volatile. It is natural to ask whether there is a connection between these two developments and, in particular, whether they are both driven by the same set of economic forces. Many have argued that the increased volume of trade is due to a reduction in the technological- and policy-induced costs of trading goods and services. 1 Is it possible that these cost reductions are also responsible for the increase in the size and volatility of trade imbalances? If so, what are the main theoretical channels through which this happens? Are these channels quantitatively important? ∗ Corresponding author