Trade Costs, Market Integration, and Macroeconomic Volatility

This paper examines the effects of trade costs on macroeconomic volatility. We first construct a dynamic, two-country general equilibrium model, where the degree of market integration depends directly on trade costs (transport costs, tariffs, etc.). The model is a extension of Obstfeld and Rogoff (1995). Naturally, a reduction in trade costs leads to more market integration, as the relative price of foreign goods falls and households increase their consumption of imported goods. In addition, with more market integration, the model predicts that the variability of the real exchange rate should fall, while the variability of the trade balance should increase. Trade costs have ambiguous effects on the volatility of other macro variables, such as income and consumption. Finally, we present some empirical findings that provide mixed support for the model''s predictions.Trade;Exchange rates;trade costs, exchange rate, transport costs, real exchange rate, aggregate demand, market integration, fiscal shock, imported goods, tariff rates, domestic shocks, tariff rate, equilibrium model, exchange rate variability, domestic consumption, trade deficit, elasticity of substitution, exchange rate volatility, domestic aggregate demand, exchange rate movements, open economy, domestic goods, nominal exchange rate, tariff barriers, real effective exchange rate, open economies, real exchange rate volatility, domestic demand, measure of trade, changes in trade, imperfect competition, effective exchange rate, exchange rate dynamics, volume of trade, exchange rate changes, political economy, exchange rate policy, real exchange rate movements, trade openness, trade patterns, domestic firms, increased openness, trade pattern, policy on exchange rates, exchange rate change, economic integration, trade protection, product differentiation, transport cost, trade barriers, factor price, multilateral trade, trading arrangements, world demand, trade liberalization, nominal exchange rates, regional trade, global trading, world trade, real exchange rates, global integration, economic cooperation, increased trade, home currency, pattern of trade, per capita income, non-tariff barriers, exchange rate determination, domestic prices, unit of labor, international trade, bilateral trade, terms of trade, national borders, low trade