### Digitized

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### in

### 2011

### with

### funding

### from

### Boston

### Library

### Consortium

### Member

### Libraries

### DEWEY

### \4f

### 1

### Massachusetts

### Institute

### of

### Technology

### Department

### of

### Economics

### Working Paper

### Series

### Comparative

### Advantage and

### the

### Cross-Section

### ot

### Business

### Cycles

### Aart

### Kraay,

### The

### World

### Bank

### Jaume

### Ventura,

### MIT

### Working

### Paper

### 98-09Revised

### January

### 2001

### Room

### E52-251

### 50

### Memorial

### Drive

### Cambridge,

### MA

### 02142

This

### paper can

### be downloaded

without### charge from

the Social### Science Research Network Paper

Collection at http://papers.ssrn.com/paper.taf7abstract id-=1### 371

### 75

MASSACHUSETTSINSTITUTE

OFTECHNOLOGY

### OCT

_{l 6}

_{2001}

### *\

### Massachusetts

### Institute

### of

### Technology

### Department

### of

### Economics

### Working

### Paper

### Series

### Comparative

### Advantage

### and

### the

### Cross-Section

### of

### Business

### Cycles

### Aart

### Kraay,

### The

### World

### Bank

### Jaume

### Ventura,

### MIT

### Working

### Paper

### 98-09Revised

### January

### 2001

### Room

### E52-251

### 50

### Memorial

### Drive

### Cambridge,

### MA

### 02142

This

### paper

### can

### be

### downloaded

without### charge

### from

the Social### Science

### Research Network

### Paper

Collection at http://papers.ssrn.com/paper.taf7abstract id-=1### 371

### 75

### Comparative

### Advantage

### and

### the

### Cross-section

### of

### Business Cycles

Aart

### Kraay

### Jaume

### Ventura

### The

### World

### Bank

M.I.T.### December 2000

Abstract: Business cycles are both less volatile

### and

### more

synchronizedwith theworld cycle in rich countriesthan in poor ones.

### We

developtwo alternativeexplanations

### based on

the ideathat comparative### advantage causes

rich countriesto specialize in industries that### use

### new

technologies operated by skilledworkers, while poorcountries specialize in industries that### use

traditional technologiesoperated by unskilled workers. Since### new

technologies are difficultto imitate, the industries of richcountries enjoy

### more

market### power

### and

face### more

inelastic product### demands

than those of poorcountries. Since skilled workers are less likelyto exit### employment

as aresult of

### changes

in### economic

conditions, industries in rich countriesface### more

inelastic labour suppliesthan thoseof poor countries.

### We

### show

that either### asymmetry

in industry characteristics### can

generate cross-country differences inbusiness cyclesthat resemble those

### we

observe inthe data.### We

aregrateful toDaronAcemogluandFabrizio Perriforusefulcomments.Theviews expressed hereBusiness cyclesare notthe

### same

in rich### and

poor countries.### A

firstdifferenceis thatfluctuations in per capita

### income

growth are smallerin rich countries than inpoorones, in the top panelof Figure 1,

### we

plotthe standarddeviation of per capita### income

growth against the level of (log) percapita### income

for a large### sample

ofcountries.

### We

referto this relationship asthevolatility graph### and

notethat it slopes### downwards.

### A

### second

difference isthat fluctuations in per capita### income

growth are### more

synchronizedwith the world cycle in rich countries than in poor ones. Inthe bottom panel of Figure 1,### we

plotthecorrelation of percapita### income

growth rateswith world average percapita

### income

growth, excluding thecountry in question,against the level of (log) percapita

### income

forthe### same

set ofcountries.### We

refertothis relationship as the

### comovement

graph### and

notethatit slopes upwards. Table 1,

which is self-explanatory,

### shows

thatthese facts applywithin different### sub-samples

ofcountries

### and

years.1### Why

are businesscycles less volatile### and

### more

synchronized with theworld cycle in rich countriesthan in poor### ones?

Part ofthe### answer must be

that poor countries exhibit### more

political### and

policy instability, they are less### open

or### more

distantfromthe geographicalcenter,### and

they also### have

a highershare oftheir### economy

devoted tothe production of agricultural products### and

theextraction of minerals. Table 1### shows

that, ina statistical sense, thesefactors explain a substantial fraction of thevariation in thevolatility of### income

growth, althoughthey### do

not explain### much

ofthe variation in the### comovement

of### income

growth.### More

importantfor our purposes, the strong relationship### between income

### and

the propertiesof business cycles reported in Table 1 is still present after### we

controlfor these variables. In short, there### must be

otherfactors behind the strong patterns depicted in Figure 1### beyond

differences in political instability,

### remoteness

### and

theimportance of natural resources.Withthe exceptionthatthecomovementgraphseemsto bedriven bydifferencesbetween rich and

poorcountriesandnot within eachgroup.AcemogluandZilibotti (1997)alsopresent thevolatilitygraph.

Theyprovideanexplanationforitbased ontheobservationthatrichcountrieshavemorediversified

In this paper,

### we

develop two alternative but non-competing explanationsfor### why

businesscycles are less volatile### and

### more

synchronizedwith the world in richcountriesthan in poor ones. Both explanations rely

### on

the idea that comparative### advantage

### causes

richcountries to specialize in industries that require### new

technologies operated by skilledworkers, while poorcountries specialize in industries that requiretraditional technologies operated by unskilled workers. This pattern of specialization

### opens up

the possibilitythat cross-country differences in businesscycles are the result of

### asymmetries

### between

these typesof industries. In particular,both ofthe explanations

### advanced

here predict that industries that### use

traditionaltechnologies operated by unskilled workers will

### be

### more

sensitive to country-specific shocks. Ceteris paribus, these industrieswill not only### be

### more

volatile but alsoless synchronizedwith the world cycle since the relative importanceof global shocks islower.

### To

the extentthatthe business cyclesof countries reflectthose of theirindustries, differences in industrial structurecould potentially explain the patterns in

Figure 1

.

### One

explanation of### why

industries reactdifferentlyto### shocks

is### based on

the ideathatfirms using### new

technologies face### more

inelastic product### demands

than those using traditional technologies.### New

technologiesare difficultto imitate quicklyfortechnical reasons

### and

also### because

of legal patents. This difficulty confersa cost### advantage on

technological leaders that shelters### them

from potential entrants### and

gives

### them

### monopoly power

inworld markets. Traditionaltechnologies are easiertoimitate

### because

### enough

time### has

### passed

sincetheir adoption### and

also### because

patents

### have

expired or### have

### been

circumvented. This impliesthat### incumbent

firms face tough competition from potential entrants### and

enjoy little or### no

### monopoly power

inworld markets.

### The

price-elasticityof product### demand

affects### how

industries react to shocks.Consider, for instance, theeffects of country-specific

### shocks

that### encourage

production in all industries. In industries that

### use

### new

technologies, firms### have

### monopoly power and

face inelastic### demands

for their products.### As

a result,competition from

### abroad and

therefore face elastic### demands

for their products.### As

aresult, fluctuations in supply

### have

little or### no

effect### on

their prices### and

industry### income

is

### more

volatile.### To

the extentthat this### asymmetry

in the### degree

of product-marketcompetition is important,

### incomes

of industries that### use

### new

technologies are likelyto### be

lesssensitive to country-specific### shocks

than those of industries thatusetraditional technologies.

Another explanation for

### why

industries react differentlyto shocks is### based on

the idea that the supplyof unskilledworkers is

### more

elastic than the supplyof skilledworkers.

### A

firstreason for this### asymmetry

is that non-market activities are relatively### more

attractive tounskilled workers### whose

market### wage

is lowerthan thatof skilledones.

### Changes

in labour### demand

might induce### some

unskilledworkersto enteror### abandon

the labourforce, but are notlikelyto affect theparticipation of skilledworkers.

### A

### second

reason forthe### asymmetry

in labour supply across skill categoriesis the imposition ofa

### minimum

### wage.

### Changes

in labour### demand

might force### some

unskilledworkers in### and

outof### unemployment,

butare not likelyto affectthe### employment

of skilled workers.### The

wage-elasticityofthe labour supply also### has

implicationsfor### how

industries react toshocks. Consider again the effects of country-specific shocksthat

### encourage

production in all industries### and

therefore raisethe labour### demand.

Since the supply of unskilledworkers is elastic,these shocks lead to large fluctuations in### employment

of unskilledworkers. In industries that### use

them,fluctuations in supply are therefore magnified by increases in### employment

that### make

industry### income

### more

volatile. Sincethe supply of skilledworkers is inelastic, the

### same

shocks### have

littleor### no

effects### on

the### employment

of skilledworkers. In industries that### use

them, fluctuations in supply are not magnified### and

industry### income

is less volatile.### To

the extentthatthis### asymmetry

in the elasticityof laboursupply is important,### incomes

ofindustries that use unskilled workersare likelyto

### be

### more

sensitive to country-specific### shocks

than those of industries that use skilledworkers### To

studythese### hypotheses

### we

constructa stylized world equilibrium### model

of the cross-section of business cycles. Inspired bythe### work

of Davis(1995),### we

consider insection

### one

a world in which differences in both factor### endowments

a laHeckscher-Ohlin

### and

industrytechnologies a la Ricardo### combine

todetermine a country's comparative### advantage

and, therefore, the patterns of specialization### and

trade.

### To

generate business cycles,### we

subjectthisworld### economy

to the sort of productivity fluctuations that### have

### been

### emphasized

by Kydland### and

Prescott (1982).2Insection two,

### we

characterize the cross-section of business cycles### and

### show

### how

### asymmetries

in the elasticityof product### demand

and/or labour supply### can be

### used

to explain the evidence in Figure 1. Using available### microeconomic

estimatesof the keyparameters,

### we

calibratethe### model

### and

find that: (i)### The

### model

exhibits slightly less than two-thirds### and

one-third ofthe observed cross-country variation in volatility### and

### comovement,

respectively;### and

(ii)### The

### asymmetry

in the elasticityof product### demand

### seems

to### have

a quantitatively stronger effect### on

theslopes of the volatility### and

### comovement

graphs, than the elasticity in the labour supply.### We

explore these results further in sections three### and

four. In section three,### we

extendthe### model

to allow for### monetary

### shocks

that### have

real effectssince firms facecash-in-advance constraints.### We

### use

the### model

to study### how

cross-country variation in### monetary

policy### and

financial### development

affectthe cross-section of business cycles.### Once

thesefactorsare considered, the calibrated versionof the### model

exhibits roughly the### same

cross-countryvariation in volatility### and

about### 40

percent of thevariation in

### comovement

asthedata. In sectionfour,### we

### show

that the two industry### asymmetries

### emphasized

here lead toquite different implications forthecyclical behaviorof the termsof trade.

### When we

confront these implicationswiththedata, thepicture that

### appears

isclear### and

confirms our earliercalibration result.Namely, the

### asymmetry

inthe### product-demand

elasticity### seems

quantitatively### more

importantthan the### asymmetry

in the labour-supplyelasticity.2

Ourresearch isrelatedtothelarge literature onopen-economyrealbusinesscyclemodelsthat

studieshowproductivityshocks are transmittedacrosscountries.See Baxter (1995)and Backus,

Kehoeand Kydland (1995)fortwo alternativesurveysof thisresearch.

### We

differfromthisliteratureintwo respects. Instead ofemphasizingtheaspects inwhich businesscycles aresimilaracrosscountries,

### The

### main

### theme

of this paperis thatthe properties of business cycles differacrosscountries

### because

they### have

differentindustrial structures.### There

are### many

determinantsof theindustrial structure of a country.

### We

focus here### on perhaps

the### most

importantof### such

determinants, that is, a country's ability totrade. In sectionfive

### we

explorefurtherthe connection### between

internationaltrade, industrial structure### and

the nature of businesscycles.### We

introducetrade frictions in theform of "iceberg"transport costs### and

study### how

globalization### (modeled

here as parametric reductions in transport costs)### changes

the nature of thebusiness cycles thatcountries experience. Iftransport costs are high enough, all countries

### have

the### same

industrial structure

### and

the cross-section of business cycles is flat.### As

transportcostsdecline, the prices of products in which a countryhas comparative

### advantage

increase

### and

so### does

their share in production.### As

a result, industrial structures diverge.### One

shouldtherefore expect globalization to lead to business cyclesthat are### more

different acrosscountries.1.

### A

### Model

### of

### Trade

### and Business

### Cycles

Inthis section,

### we

present a stylized### model

ofthe world### economy.

Countries that### have

bettertechnologies### and

### more

skilledworkersare richer,### and

alsotend to specialize in industries that use these factors intensively. Thatis, the### same

characteristics thatdeterminethe

### income

of a country also determine its industrialstructure.

### Our

objective isto develop a formal### framework

that allowsus to thinkabout### how

cross-countryvariation in industrial structure,### and

therefore income, translatesintocross-country variation in the propertiesof the business cycle.

### We

considera worldwith a continuum ofcountries with### mass

one;### one

final### good and

two### continuums

of intermediates indexed by ze[0,1],which### we

refertoas the a-### and

(3-industries;### and

two factorsof production, skilled### and

unskilledworkers.### There

is freetrade in intermediates, but### we

### do

not allowtrade inthe final good.### To

simplifythe

### problem

further,### we

also rule out investment. Jointly, these assumptions imply that countries### do

notsave.Countries differ in theirtechnologies, their

### endowments

of skilled### and

unskilledworkers

### and

their level of productivity. In particular,### each

country is definedby atriplet (n,5,7t),

### where

\iis### a

### measure

of### how

### advanced

thetechnology ofthe country is, 5is the fraction ofthe population that isskilled,### and

n is### an

index of productivity.### We

### assume

thatworkers cannot migrate### and

that cross-countrydifferences in technology arestable, sothat \i

### and

5are constant. Let F((i,5)### be

theirtime-invariantjoint distribution.

### We

generate businesscycles byallowing the productivity index### n

to fluctuate randomly.### Each

countryis populated by a### continuum

of### consumers

### who

differ intheirlevel of skills

### and

their personal opportunity cost of work, or reservation### wage.

### We

think ofthis reservation

### wage

as thevalueof non-market activities.### We

index### consumers

by ie[1,»)### and

### assume

thatthis index is distributed accordingto thisPareto distribution: F(i)

### =1-i

_x, with X>0.### A

### consumer

with index i### maximizes

thefollowing expected utility:

(1) Ejufc(i)

### WVe-.dt

o v

### ';

### where

U(.) is### any

well-behaved utilityfunction; c(i) is consumption of thefinal### good

### and

l(i) is### an

indicatorfunction thattakes value 1 if the### consumer

### works and

otherwise. Let r(|i,5,7i)

### and

w(fx,8,7t)### be

the### wages

ofskilled### and

unskilled workers in a(H,5,7t)-country. Alsodefine _{p}_{F(n,8,7t)} astheprice of the final good.

### The

budgetconstraint is simply p_{F} •_{c(i)}=

### w

•l(i) for unskilledworkers### and

pF •c(i)=_{r}•

_{l(i)}for

skilled ones.

### The consumer

### works

if### and

only ifthe applicable real### wage

(skilledorunskilled)

### exceeds

a reservation### wage

of i" 1of skilled

### and

unskilled workersthat are employed.### Under

theassumption that thedistribution of skills

### and

reservation### wages

are independent,### we

### have

that(2) (3) f - \

### vPf,

u### =

\ (1-5)### 'w^

### K^J

### 1-5

if r### <

_{p}

_{F}if r

### >

_{p}F if

### w

### <

_{p}

_{F}if

### w

### >

_{p}F

Ifthe real

### wage

of### any

type of workeris less than one, theaggregate labour supplyof this type exhibits awage-elasticityof X. This elasticity### depends

only### on

the dispersion of reservation### wages.

Ifthe real### wage

of### any

type ofworker reachesone,theentire labour forceof this typeis

### employed and

the aggregate laboursupply for thistypeof workers### becomes

vertical. Throughout,### we

consider equilibria in which thex

real

### wage

for skilled workers### exceeds

one,### —

### >

1 , whilethe real### wage

forunskilledPf

### w

workers is less than one,

### —

<1 . That is, all countries operate in thevertical regionPf

of their supplyof skilledworkers

### and

the elastic region of theirsupplyof unskilledworkers. This assumption generates

### an

### asymmetry

inthe wage-elasticity of the aggregate laboursupply across skill categories. Thiselasticityis zero for skilledworkers

### and

### X>0

for unskilledones.### As

X-^0, this### asymmetry

disappears.### Each

country contains### many

competitivefirms in thefinal### goods

sector.### These

firms

### combine

intermediatesto### produce

thefinal### good

according tothiscostfunction:Thisisthecaseinequilibriumifskilled(unskilled)workersaresufficientlyscarce (abundant) inall

(4) B(p_{a}(z),p
p(z))

### =

V 1-v "1 M) "1 1-e### JPa(zr

### dz

_{Jp}

P(z)
1- e
dz
_0 .0
### The

elasticity ofsubstitution### between

industries is one, while theelasticityofsubstitution

### between any two

varieties within### an

industry is9, with 6>1.

Sincethereare always

### some

workersthat participatein the labourforce, the### demand

forthefinal product is always strong### enough

to generate positive productionin equilibrium.

### Our assumptions on

technology implythatfirms in the final### good

sector

### spend

a fraction vof their### revenues

### on

a-products### and

a fraction 1-v### on

(3-products. Moreover, the ratioof spending

### on

### any

two a-products z### and

z' is given byPa(z) P.(z')

1-e

;

### and

the ratioof spending### on

### any

two (3-products z### and

z' isPp(z)

Pp(z')

1-e

### where

pa(z)### and

p (z) denote theprice of varietyz of the a-### and

(3-products,respectively. Define P_{n}

### and

Pp asthe ideal price

indices forthe a-

### and

(3-industry, i.e.### P

_{a}

### =

### Jp

a(z) 1- 9 -dz### and P

R =### Jp

p(z) 1- e -dz 1 1-e;

### and

define thefollowingnumeraire rule:

(5) 1

### =

P«v

-Pp"v

Sincefirms inthefinal

### goods

sector are competitive, they set price equals cost. This implies that:(6) pF

### =1

Sinceall intermediates aretraded

### and

the lawof### one

price applies, the price### power

parity applies.### An

implication of this isthat the### assumption

thatthe final### good

is nottraded is not binding.### Each

country also containstwo intermediate industries.### The

a-industry uses sophisticated production processes that require skilled workers.### Each

variety requires a differenttechnology that is### owned

by### one

firm only.### To

### produce

### one

unitof### any

variety ofa-products, thefirm that

### owns

the technology requires### e"

units of skilledlabour.

### As

mentioned, the productivityindexn fluctuates### randomly

### and

is not under thecontrol ofthefirms. Let_{n}

### be

the### measure

of a-productsin which thetechnologyis

### owned

by a domestic firm.### We

### can

interpret_{n}

as a natural indicator of ### how

### advanced

the technologyof a country is. Itfollowsfrom our### assumptions on

thetechnology

### and

market structurein thefinal### goods

sector thattheelasticityof### demand

for### any

varietyof a-product is 0.### As

a result, allfirms in the a-industry facedownward-sloping

### demand

curves### and behave

monopolistically. Their optimal pricing policyis to set a### markup

over unitcost. Let pjz) bethe price ofthevariety z of the a-industry.### Symmetry

ensures all thefirmslocated in a (|i,8,7i)-country setthe### same

pricefor theirvarieties of a-products, _{p}

a(ja,8,7r):

(7) paa =

### re"

### 6-1

### As

usual, the### markup depends on

the elasticityof### demand

for their products.### The

(3-industryuses traditional technologiesthat are available to all firms in allcountries

### and can be

operated by both skilled### and

unskilledworkers.### To

### produce one

unit of any varietyof (3-products firms require e" units of labourof

### any

kind. Since### we

### have

### assumed

that inequilibrium skilled### wages

### exceed

unskilled### wages,

onlyunskilled workers produce (3-products. Sinceall firms in the (3-industry

### have access

to the### same

technologies, they all faceflat individual### demand

curves### and behave

competitively.

### They

set priceequal to cost. Let_{p}(z)

### be

the price ofthevariety z ofthe (3-industry.

### Symmetry

ensures that all firms in the P-industryof a (n,5,7r.)-countrysetthe

### same

price forall varieties of_{(3-products, p^n,S,n):}

(8) p_{p} =w-.e-"

With this formulation,

### we

### have

introduced### an

### asymmetry

in the price-elasticity of product### demand.

This elasticity is in the a-industry### and

infinity inthe (3-industry.### As

### 0^co

; this

### asymmetry

disappears.Business cycles arise as

### n

fluctuates randomly.### We

refer to### changes

in### n as

productivity shocks.

### The

index### %

is the### sum

of a global### component,

n,### and

a country-specific### component,

n-Y\.### Each

of these### components

is### an

independent Brownianmotion reflected

### on

the interval [-1,1] with### changes

that### have

zero drift### and

instantaneous variance equalto r\a2

### and

(1-r|)rj2 respectively, with### %

>0, 0<r|<1### and

a>0. Letthe initial distribution of country-specific

### components

### be

uniformly distributed### on

[-n,7i]### and

### assume

this distribution is independentof other countrycharacteristics.

### Under

the### assumption

that### changes

in these country-specific### components

are independent across countries,### we

### have

thatthe cross-sectionaldistribution of 71-n istime invariant.4

### We

refer tothisdistribution as G(7i-n). While### n

has

### been

defined### as

### an

index of domesticproductivity,### n

serves as### an

indexof world### average

productivity.### The

parameter### a

regulates thevolatilityofthedomestic shocks.### The

instantaneous correlation### between

domestic shocks, dn,### and

foreign shocks, dn,is therefore Jr) .

5

### The

### parameter

ti therefore regulates the extentto which thevariation in domestic productivity is

### due

to global or country-specific### components,

i.e.whetherit

### comes

from### dn

or d(7i-n). Figure 2### shows

possible### sample

paths_{of}

### n

underthree alternative

### assumptions

regardingt|.4

SeeHarrison(1990),Chapter5.

Thisistrueexceptwheneithernor

### n

areattheir respectiveboundaries.These arerareevents since### A

competitive equilibrium ofthe world### economy

consistsof a### sequence

of prices### and

quantities### such

that### consumers and

firms### behave

optimally### and

marketsclear.

### Our assumptions

ensurethat a competitive equilibrium exists### and

is unique.### We

provethis byconstructing theset of equilibrium prices.In thea-industry, different products

### command

different prices.### The

ratio ofworld

### demands

forthe### (sum

of all) a-products of a (^,5,7i)-country### and

a(n',d',n')-country,

### —

### P.W

,### must

equal the ratio of supplies is### se'

### se

Pa(z')

condition plus Equation (2)

### and

the definition of Pa

### we

find that: . Usingthis (9) Pa### v

a### H

1 ^9 n-n### where

*¥„### =

### IW

1 e-1### 8

### —

9 (n-n)_{dF-dG}

v.
Since the distribution functions F(u.,8)

J

### and

G(n-n) aretime-invariant, x### ¥

_{a}is aconstant. Since

### each

country isa "large" producer of its### own

varieties of a-products, the price ofthesevarieties### depends

negatively

### on

the quantityproduced. Countrieswith### many

skilled workers (high 8)with relatively high productivity (high 7i-n) producing a small

### number

of varieties (low|i) produce large quantitiesof

### each

variety ofthe a-products### and

as a result, face low prices.### As

9^>°°, the dispersion in theirprices disappears### and

_{p}

ra(z)—>pa

.

Inthe (5-industryall products

### command

the### same

price. Otherwise, low-pricevarieties of (3-products would not

### be

produced. Butthis is nota possible equilibrium given the technology described in Equation (4). Therefore, itfollows that:(10) Pp

Finally,

### we

### compute

the relativeprice of both industries.### To

### do

this, equatev

the ratio of world spending in the a-

### and

(3-industries, ,to the ratio of thevalue### 1-v

### ffp

_{a}

### s-e"dFdG

of their productions,

### ^

. Using Equations_{(2)-(3)}

### and

_{(5)-(10),}

### we

j

### jPpue

n

### dFdG

then find that:

(11)

### P

1 f v### %

### \~

### 1-v

### W

n 1+X.-V### —

-### —

n 1+Xv •e*### where

### y

p### =

### JJ(1-5)-e

(1+X)(n_n)_{dFdG}

,

### and

is constant. IfX>0, high productivity isassociated with high relative pricesfor a-products as theworld supplyof (3-products

is high relativeto thatof a-products. This increasein the relative supplyof (3-products

is

### due

to increases in### employment

of unskilledworkers.### As

A.-^0, the relative prices ofboth industries are unaffected bythelevel of productivity.

### What

are the patterns oftrade inthisworld### economy?

Lety(n,§,7i)### and

x(n,5,Tr)

### be

the### income

### and

theshare of the a-industry in a (n,5,7i)-country, i.e./ \ d •s•o

71

y

### =

(pa •s### +

pp

•

### u}

e"### and

x### =

### —

. Notsurprisingly, countrieswith bettertechnologies _{(high n)}

### and

### more

### human

capital (high 5)### have

highvalues for both_{y}

### and

x.### We

therefore refer to countries with high values ofx### as

rich countries. Since### each

country### produces an

infinitesimal### number

of varieties of a-products### and uses

allof

### them

in the production offinal goods, all countries exportalmost all of theirproduction of a-products

### and

importalmost all of the a-products### used

in thedomestic production of final goods.### As

### a

shareof income, these exports### and

imports are x### and

v, respectively.

### To

balancetheir trade, countrieswith### x<v

export (3-products### and

v-x

### and

x-v, respectively. Therefore, the share of trade in### income

is max[v,x].### As

usual, thistrade can### be

### decomposed

into intraindustry trade, min[v,x],### and

interindustrytrade,Ix-v| .

### The

former consistsof trade in productsthat### have

similarfactor proportions.

### The

laterconsistsof trade in productswith different factorproportions.

### The

### model

thereforecaptures in a stylized### manner

three broad empirical regularities regarding the patterns of trade: (a) a large### volume

of intraindustry trade### among

rich countries, (b) substantial interindustrytrade### between

rich### and

poorcountries,

### and

(c) littletrade### among

poorcountries.### 2.

### The

### Cross-section

### of

### Business

### Cycles

Inthe world

### economy

described in the previoussection, countries are subjecttothe

### same

type of country-specific### and

global### shocks

to productivity.### Any

differencein the properties oftheir business cycles

### must be

ultimately attributed to differencesin theirtechnology

### and

factorproportions. This is clearly asimplification. Inthe realworld countriesexperience differenttypesof

### shocks

### and

also differ in### ways

that### go

### beyond

technology### and

factor proportions. With thiscaveat in mind, in this section### we

ask:### How

### much

of the observed cross-countryvariation in business cycles could potentially### be

explained bythesimple### model

of theprevious section?### Perhaps

surprisingly, the

### answer

is### between

### one

### and

two thirds ofall the variation.### The

first steptowards answering this question isto obtain### an

expression thatlinks

### income

growth tothe shocksthat countries experience. Applying Ito's### lemma

tothe definition of y

### and

using Equations (2)-(11),### we

obtain the### (demeaned)

growthrate of

### income

ofa (n.,5,7t)-country### as

### a

linearcombination of country-specific### and

global shocks: (12)

### dlny-E[dlny] =

x-### —

+(1-x)-(1+X)### d(7t-n)+

1+ x### dn

### 1+X-v

15Equation (12) provides a complete characterization ofthe businesscycles experienced by a (u.,5,7i)-countryas afunction ofthe country's industrial structure,

### as

### measured

byx. Equation (12)### shows

that poorcountries are### more

sensitive to### 3dlny

country-specific shocks, i.e.

ad(Ti-n)

is decreasing in x. Equation (12) also dn=o

### shows

thatall countries are equally sensitive to global shocks, i.e### adn

independentof x.

### We

nextdiscuss the intuition behind these results.is d(;t-n)=o

### Why

are poorcountries### more

sensitiveto country-specific### shocks?

### Assume

that

### X-^0

### and

### 9^°°

>### so

thatthe### a-and

(3-industryface both perfectly inelasticfactorsupplies

### and

perfectly elasticproduct### demands.

Inthiscase, a### one

percent country-specific increase in productivity### has

noeffects on### employment

or product prices.### As

aresult, production

### and income

also increase by### one

percent. This is### why

### 3dlny

ad(Ti-n)

### =

1 if A.-^0### and

### 6^^.

If A,is positive, a country-specific increase indn=o

productivityof

### one

percent leadsto### an

increase in### employment

of A. percent in the(3-industryand, as a result, production

### and income

increase by### more

than### one

percent. This### employment

response magnifiesthe expansionary effects of increasedproductivity in the (3-industry.

### As

a result, the### shock

### has

stronger effects in poor 3dlnycountries, i.e.

3d(7t-n)

### =

1### +

(1—x)-A, if### 8—

>°°. If6 is finite, a country-specific dn=oincrease in productivity of

### one

percent leads toa 0"1percent

### decrease

in prices inthea-industries. Thisprice

### response

counteracts the expansionaryeffects of increased productivity inthea-industry. Consequently, the### shock

has### weaker

effects in richBdlny countries, i.e.

x

### =

1### —

ifX=0. If### X>0 and

9 isfinite,### we

### have

that both the### employment

### and

price### responses combine

to### make

poor countries react### more

tocountry-specific shocks, i.e.

dd(Ti-n)

### —

1### =

x### +

(1-x) (1### +

X) is decreasing in x.### Why

areall countries equally responsiveto global### shocks?

This result rests### on

theassumption thattheelasticity of substitution### between

a-### and

(3-productsisone. Consider a global increase in productivity.

### On

the### one

hand, production of p-products### expands

relativeto the production of a-productsas### more

unskilled workers are employed. Ceteris paribus, this### would

increase the share ofworld### income

that### goes

tothe p-industry,### and hence

poorcountries, aftera positive global shock. But theincrease in relative supply lowers the relative price of p-products. This reduces theshare ofworld### income

that### goes

to the P-industry,### and hence

poorcountries, after a positive global shock.### The

### assumption

ofa### Cobb-Douglas

technologyfortheproduction ofthe final

### good

implies that thesetwoeffectscancel### and

theshare ofworld spending in the a-

### and

P-industries remains constant overthe cycle. Therefore,in our

### framework

differences in industrial structure### do

notgenerate differences in### how

countries react to global shocks.6

### We

are readyto### use

the### model

to interpretthe evidence in Figure 1. DefinedlnY

### as

theworld average growth rate, i.e.### dlnY =

jj dlny

### dFdG

. Then, it followsfrom Equation (12) that:

(13)

### dlnY-E[dlnY]

### =

1

### +

### X

### dn

1

### + A-v

Sincethe lawof large

### numbers

eliminates the country-specific### component

of### shocks

in the aggregate, the world### economy

exhibits mildercyclesthat### any

ofthe countriesthat belong to it.7

6

WhiletheCobb-Douglasformulation isspecial, itisnotdifficulttograsp whatwould happenifwe

relaxed it. Iftheelasticity ofsubstitutionbetween industrieswerehigherthan one, poorcountrieswould

be moresensitivetoglobalshocksthanrichcountriesastheshareofworld incomethatgoestothe

|3-industry increasesafterapositiveglobalshock and decreasesafteranegative one. Iftheelasticity of substitutionwere lessthan one, the oppositewould betrue.

7

Once again,this resultrestsontheCobb-Douglas assumption. Iftheelasticityofsubstitutionbetween

a-and|3-productswere higherthan one, the very richcountries mightexhibitbusinesscyclesthatare

milderthan thoseoftheworld.

Let V(n,8,7i)

### denote

the standarddeviation of### income

growth of a(u.,5,7t)-country,

### and

let CQx,5,7c)### denote

thecorrelation of its### income

growth with world### average income

growth.### These

are the theoretical analogs to thevolatility### and

### comovement

### graphs

in Figure 1. Using Equations (12)-(13)### and

the propertiesoftheshocks,

### we

find that:(14)

### V

### =

o-. (15)### C

### =

x### .^I

### +

(1-x)-(1### +

X) -i2 (1"T1)+ '### ^+x

^ -\### + X-v

1### +

### 1-v

### f\

x### .®^

### +

(1-x)-(1### +

X) •(1-71)### +

1### + A

1### + X-v

TlFigure 3 plotsthe volatility

### and

### comovement

### graphs

asfunctionsof x, fordifferentparameter values. Exceptin the limiting

### case where

both### X=0

### and

0=<~, thevolatilitygraph is

### downward

sloping### and

the### comovement

graph is### upward

sloping.### The

intuition is clear:### As

a result of### asymmetries

in theelasticity of### product-demand

### and

labour supply, the a-industryis less sensitive to country-specific### shocks

thanthe(3-industry. This

### makes

the a-industry lessvolatile### and

### more

synchronizedwith theworld cyclethan the (3-industry. Sincecountries inherit the cyclical properties of their

industries, the

### incomes

of rich countries are also lessvolatile### and

### more

synchronized with the world cyclethan thoseof poorcountries.### The

### magnitude

of these differencesis

### more

### pronounced

as### X

increases and/or 6 decreases.### A

simple inspection of Equations (14)### and

(15) revealsthat there existvarious combinations of### parameters

capable of generating approximatelythe data patterns displayed in Figure 1### and

Table 1. Inthis sense, the### model

is able to replicate theevidencethat motivated the paper. Butthis is a very

### undemanding

criterion.### One

can### impose

### more

discipline### by

restrictingthe analysis tocombinations of parameter values that### seem

reasonable.### To

### do

this,### we

next### choose

valuesfor a, r\, v### and

abusinesscycles varies with X

### and

9. Needlessto say,### one

should### be

cautious to### draw

strong conclusionsfrom a calibration exercise likethis in a

### model

asstylized### as

ours.### As

noted above, in the realworld countries experience differenttypesof### shocks

### and

alsodiffer in

### ways

that### go beyond

technology### and

factorproportions. Moreover,availableestimates of the key parameters

### X

### and

9are### based on

non-representative### samples

ofcountries### and

industries, sothat caution is in order### when

generalizing to the largecross-section of countries### we

study here. Despite these caveats,### we

shallsee that

### some

useful insights can### be

gained fromthis exercise.### To

determinethe relevant rangeof variationforx,### we

use data### on

trade shares.### The

### model

predicts thatthe share of exports in### income

in rich countries is x.Sincethis share is

### around 60

percent inthe richest countries in our sample,### we

### use

0.6 as a reasonable upper

### bound

for x.### The

### model

also predicts that v is theshare of exports in### income

in poor countries,### and

that in these countries x<v. Sincethe shareof exports in

### GDP

is### around 20

percent inthe poorestcountries in oursample,### we

### choose

v=0.2### and

use0.1 as alower### bound

forx.### The

choice ofrj### and

r\ is### more

problematic, since there are

### no

reliableestimates of the volatility### and

cross-country correlation of productivitygrowth for this large cross-section of countries.### We

circumventthis

### problem

by choosing### a and

r| to### match

theobserved level of volatility### and

### comovement

of### income

growthforthetypical rich country, given the rest of our parameters.8 This### means

thatthis calibration exercise### can

only tell us aboutthemodel's abilityto

### match observed

cross-country differences involatility### and

### comovement

of### income

growth.### The

top-left panel ofTable 2 reportsthe resultsof this calibration exercise,### and

selected### cases

are### shown

in Figure 3.### The

first row reportsthe predicted difference in volatility### and

### comovement

### between

the richest country(with log per capita### GDP

of around 9.5)### and

the poorestcountry (with log percapita### GDP

of around 6.5),### based on

the regressionswith controls in Table 1.### The

remaining### rows

In particular,a andr|arechosentoensurethatV=0.04 andC=0.4,forx=0.5,v=0.2andthe given

choicesforAand9.

report the difference involatility

### and

### comovement

### between

the richest (x=0.6)### and

poorest (x=0.1) countries thatthe

### model

predicts fordifferent valuesof### X

### and

0.### These

values### encompass

existing### microeconomic

estimates. Available industry estimates ofthe elasticity of export### demand

range from 2to 10 (see Trefler### and

Lai (1999), Feenstra, (1994)), whileavailable estimatesforthe labour supply elasticity ofunskilled workers range from 0.3 to 0.35

### (See

Juhn,### Murphy and

Topel (1991)).### The

table also reports thevaluesfor### a

### and

r\that resultfrom the calibration procedure.Table 2

### shows

that, using values for8### and

X of### 9=2 and

A.=0.35, the### model

can accountfor nearlytwo-thirds ofthe cross-country difference in volatility

### between

rich

### and

poorcountries (-0.016versus -0.026),### and

slightly lessthan one-third ofthe cross-country differences in### comovement

(0.129 versus 0.382).### These

values forthe parameters are within the range### suggested by

existing### microeconomic

studies. Iftheindustry

### asymmetries

are### assumed

to### be even

stronger, say 9=1.2### and

X=0.7, the predicted differences in volatility### and

### comovement

are closerto their predicted values.### These

results### seem

encouraging.### The

### two

hypotheses put forward here### can

accountfora sizeable fraction of cross-country differences in business cycles

### even

in### such

a stylized### model as

ours. Moreover,### we

shall### see

in the next section that a simple extension ofthe### model

that allowsfor### monetary shocks

### and

cross-country differences in the### degree

offinancial### development

can### move

thetheoretical predictions closerto the data.### A

### second

resultin Table 2 isthatthe### asymmetry

in theelasticity of product### demand seems

quantitatively### more

importantthan the### asymmetry

in theelasticity ofthe labour supply. Within the range of

### parameter

values considered in Table2,### changes

in 9### have

strong effects### on

the slopeof the two graphs, while### changes

in### X

to

### have

little or### no

effect.### To

the extentthatthis range of parameter values### we

consider is the relevant one, this calibration exercise suggeststhat the

### asymmetry

in### asymmetries

in the elasticity of product### demands

constitutesthe### more

promising hypothesisof### why

business cycles are different across countries.### We

return to thispoint in section four

### where

### we

attemptto distinguish### between hypotheses by

### 3.

### Monetary

### Shocks and

### Financial

### Development

### Our

simple calibration exercise tells us thatthe two industry### asymmetries

### can

account for almosttwo-thirds of the cross-country differences in volatility,

### and

nearly one-third ofthe cross-country variation in### comovement.

### One

reaction tothisfinding isthatthe

### model

is surelytoo stylized to### be

confronted with the data. Afterall,### most

of our modelling choices### were

### made

to### maximize

theoretical transparency ratherthan### model

fit.### Now

thatthe main### mechanisms

### have

### been

clearlystated### and

the intuitionsbehind

### them

developed, it is timeto build### on

the stylized### model

### and

### move

closertoreality by adding details. This is the goal of this section,

### where

### we

### show

thatbyintroducing

### monetary

shocks### and

cross-countryvariation infinancial### development

helps to significantlynarrowthe

### gap

### between model and

data. This is not the only### way

to narrow this gap, but### we

### choose

to followthis route### because

the elementsthatthis extension highlights areboth realistic

### and

interesting in their### own

right.### We

### now

allow countriesto differalso in theirdegree offinancial### development

### and

their### monetary

policy.### Each

country is therefore defined by a quintuplet,(|j.,5,7:,k,i),

### where

k is a### measure

ofthe### degree

of financial development,### and

i isthe interest rate### on

domestic currency.### We

### assume

thatk is constant over time### and

re-define F(^,5,k) asthe time-invariantjointdistribution of \i, 8

### and

k.### We

allowfor### an

additional source of business cyclesby letting ifluctuate randomly.

### We

motivate the use of### money

by### assuming

thatfirms facea cash-in-advance constraint.9 In particular, firms### have

to### use cash

or domestic currency in orderto### pay

afraction k of their

### wage

bill before production starts, with### 0<k<1

.### The

### parameter

ktherefore

### measures

### how

underdeveloped are credit markets.### As

### k^O

in all countries,### we

reach the limit inwhich credit marketsare so efficientthat### cash

is neverused.SeeChristiano,Eichenbaum andEvans (1997)fora discussionof relatedmodels.

This is the

### case

### we

### have

studied so far. In thosecountries### where

k>0, firms borrow### cash

from the### government

### and

repaythe### cash

plus interest after production is### completed

### and

output is sold to### consumers.

### Monetary

policy consists of settingthe interest rate### on cash

### and

thendistributing the proceeds in a

### lump-sum

fashion### among

### consumers.

### As

is### customary

in the literature

### on

### money

### and

business cycles,### we

### assume

that### monetary

policy is### random.

10 In particular,### we

### assume

thatthe interest rate is a reflecting Brownian motion### on

the interval [i,T], with### changes

that### have

zerodrift, instantaneousvariance §2,

### and

are independent acrosscountries### and

also independentof### changes

in n. Letthe initialdistribution of interest rates### be

uniform in [t,T]### and

independentofthe distribution of othercountry characteristics. Hence, the cross-sectional distribution of i, H(i),

### does

not### change

overtime.### The

introduction of### money

leads onlyto minor### changes

in thedescription ofworld equilibrium in section one. Equations (2)-(3) describing the labour-supply

decision

### and

the numeraire rule in Equation (5) still apply. Sincefirms in thefinalsector

### do

not### pay

### wages,

their pricingdecision is still given by Equation (6).### The

cash-in-advance constraintsaffect thefirms in the a-

### and

(3-industriessince they### now

face financing costs in addition to labour costs.

### As

a result, the pricing equations (7)-(8)### have

to### be

replaced by:11(16) pa

### =—

### -r-e-™

### e-1

(17) pp

### =w-e"

10

Thissimplification isadequate ifonetakes the viewthatmonetarypolicy hasobjectivesotherthan

stabilizingthecycle. Forinstance,iftheinflationtaxisusedtofinancea publicgood, shockstothe

marginal valueof thispublicgoodare translatedintoshockstotherateofmoneygrowth. Alternatively,if

acountryiscommittedtomaintainingafixed parity,shockstoforeign investors'confidence inthe

country aretranslatedintoshockstothe nominalinterestrate, asthe monetaryauthoritiesusethe latter

tomanagetheexchangerate.

11

Note that

### changes

in theinterest rate affectthe financing costs of firms### and

are therefore formally equivalenttosupplyshocks such as

### changes

in production or payroll taxes. Formally, this isthe only### change

required.### A

straightforward extensionof earlier

### arguments

### shows

that Equations(9)-(11) describing the set of equilibriumprices arestill valid provided

### we

re-define### T

p =

### J||(1-5)e

(1+A)(7t"_{n)}"Kl

### dFdGdH,

which converges to the earlier definition of

### Y

B inthe limiting

### case

in which k-^0 in all

countries.

Financing costs are not a directcost forthe country

### as

a### whole

but only a transferfrom firms to### consumers

via the government. Consequently,### income

### and

the/ \ p -s-e"

shareof the a-industry are still defined

### as

y### =

\pa s### +

pp•u) e

### and

x### =

### —

,

respectively.

### Now

rich countries arethosethat### have

bettertechnologies (high_{n),}

### more

### human

capital (high 5)### and

better financial### systems

(low k).### Remember

that,ceterisparibus, a highvalue for u.

### and

S lead to a high valueof x. This is### why

have### been

referring tocountries with high values for xas rich.### However,

### we

### have

### now

that a low valuefor k leads to both higher### income and

a lower value for x.### The

intuition issimple:

### A

high valueof k is associatedwith higher financing costs### and

thereforea### weaker

labour### demand

forall typesof workers. Inthe market for skilledworkers, this### weak

### demand

is translated fully into low in### wages

### and

has### no

effects in employment.### The

size of the a-industry istherefore notaffected by cash-in-advance constraints. Inthe marketfor unskilled workers,this

### weak

### demand

is translated into both lower### wages

### and employment.

### The

latter implies a smaller (3-industry. Despite this,### we

shallcontinueto referto countries with highervalues ofxas rich. That is, it

### seems

tousreasonable to

### assume

thattechnology### and

factor proportionsare### more

important determinantsofa country's industrial structurethan the### degree

offinancial development.### We

are readyto determine### how

interest-rate### shocks

affect### income

growth### and

the cross-section of businesscycles. Applying Ito's

### lemma

tothedefinition ofy,### we

find this expression forthe

### (demeaned)

growth rate of### income

forthe (|n,5,7t,K,i)-country: (18) dlny-E[dlny]= x### .®-l

### +

(1-x)-(1### +

X)### d(7t-n)+

### 1+

### dn-(1-x)A-K-di

J \### +

### Xv

Equation (18), which generalizes Equation (12), describes the business cycles of a (|j,,S,7i,K,i)-country

### as

### a

function of its industrial structure.### The

first### two

termsdescribe the reaction of thecountryto productivity

### shocks

### and have

### been

discussed at length.### The

third term is### new

### and

### shows

### how

the country reactsto interest-rate shocks. In particular, it### shows

that interest-rate### shocks

### have

largereffects incountriesthatare poor

### and have

a low### degree

offinancial development. That is,3dlny 9di

is decreasing in x

### and

increasing in k (holding constantx). d(rc-n)=odn=o

### An

increase in the interest rate raisesfinancing costs in the a-### and

(3-industries. This increase is larger in countries with low

### degrees

offinancial### development

(high k). Just### because

ofthis, poorcountries are### more

sensitive to interest-rate### shocks

than rich countries. But there is more. Inthe a-industry,the supply of labour is inelastic### and

the additional financing costs are fully### passed

toworkers in theform of lower

### wages.

Production is therefore notaffected. Inthef3-industry, thesupplyof labour is elastic

### and

theadditional financing costs are onlypartially

### passed

to### wages.

### Employment

### and

production thereforedecline. In theaggregate, production

### and income

decline after a positive interest-rate shock. But ifthe

### asymmetry

in the laboursupply elasticity is important, this reaction should### be

stronger in poorcountries that

### have

larger (3-industries. This provides a### second

reason

### why

poorcountriesare### more

sensitiveto interest-rate shocks than richcountries.

### The

introduction of interest-rate### shocks

provides two additional reasons### why

through their industrial structure

### and

anotheris a### consequence

of their lack offinancial development. Both of theseconsiderations reinforcethe results of the

previous model.

### To

### see

this, re-define### dlnY =

f|fdlny

### dFdGdH.

Equation (13) still

applies since

### monetary

### shocks

arecountry-specific### and

the lawof large### numbers

eliminatestheir effectsin the aggregate. Then, rewrite the volatility### and

### comovement

graphs asfollows: (19)

### V=

### a

2 (20)### C

### =

### a

2 .### x-iLl

_{+}

(1-x).(1### +

A.) (1-T1)### +

### 1+X

f 1 +### x

^ \ 1### + X-v

1### +

### X-v

2 12 Tl### +r-K^-(i-xr-A.'

x### .8_1

+(1_x).(1+X) (1-tl)### +

'_{1+X}

^
1### +

### X-v

2 ,,-2 I* „\2 t2 •Tl### +r-K^-(1-Xr-X'

j### These

equations are natural generalizations of Equations (14)-(15).### They

### show

that, ceteris paribus, countrieswith lowfinancial### development

will### be

both### more

volatile

### and

less correlated with the world.### They

also### show

the### new

channel throughwhich industrial structure affectsthe business cycles ofcountries.

With these additionalforces present, the

### model

is### now

ableto### come much

closertothe observed cross-countryvariation involatility### and

### comovement

using values for9### and X

that are consistentwith available### microeconomic

studies. This is### shown

in the bottom panelof Table 2,### where

### we

### assume

thatthe standard deviation of### shocks

to### monetary

policy is 0.1### and

thatk=1 in the poorest countries in our### sample and

k=0.5 in the richest countries. For### 9=2 and

X=0.35, the extended### model

### now

delivers cross-country differences in volatilitythatare nearly identical tothe### ones

### we

estimated in Table 1 (-0.024versus -0.026),### and

cross-country differences in### comovement

are### now

### 40

percentof those### we

observe in reality(0.165 versus 0.382). Looking further### down

thetable,### we

can further improvethe fitof the### model

in the### comovement

dimension byconsidering### more

extreme parametervalues.### However,

this is achievedat the cost of over-predicting cross-country differences in volatility.

### We

could tryto furthernarrowthe### gap between

theory### and

databyconsidering additional extensions to the model. But

### we

think thatthe results obtained sofar are sufficientto establish that thetwo hypotheses considered here### have

the potential to explain at least in part### why

business cycles are different in rich### and

poor countries. This isour simple objective here.### 4.

### The

### Cyclical

### Behavior

### of

### the

### Terms

### of

### Trade

### From

the standpoint of the evidence reported in Table 1### and

the theorydeveloped in the previous sections, the two industry

### asymmetries

studied hereare observationally equivalent.### However,

using### microeconomic

estimates for9### and X

as additional evidence to calibrate the model,### we

found that the### asymmetry

in theelasticityof product

### demand

### seems

a### more

promising explanation of### why

businesscycles aredifferent across countriesthan the

### asymmetry

in theelasticity of the labour supply. Inthis section,### we

### show

that thesetwo### asymmetries have

differentimplications forthe cyclical properties of theterms of trade,

### and

then confronting these implications with thedata.### The

evidence### on

thecyclical behavior of theterms oftrade is consistent with the results ofour calibration exercise. Namely, a strong

### asymmetry

inthe elasticityof product### demand

helps the### model

provide a### more

accurate description of theterms oftrade datathan a strong

### asymmetry

in theelasticityof the labour supply.

### We

firstderivethe stochastic process forthetermsof trade.Let T((i,5,7t,k,i)denote the

### terms

of trade of a (|a,5,7r,K,i)-country. Using Equations (9)-(11),### we

findthatthe (detrended) growth rate in theterms of trade is equalto:12

12

Itispossibletodecomposeincomegrowthintothegrowth ratesofproductionandtheterms oftrade.

Thegrowth rateofproduction(or

### GDP

growthrate)measuresincomegrowththat isdueto changesinproduction, holding constantprices.Thegrowthrate ofthetermsoftrademeasuresincome growththat

isduetochanges in prices,holdingconstant production.

### We

followusualconvention anddefinethetermsoftradeofa countryasthe ideal priceindexofproductionrelativetotheideal price indexof

expenditure.Thegrowth rateofthetermsoftradeisequaltotheshareofexportsin incometimesthe

(21)

### dlnT-E[dlnT] =

### --d(7i-n)+

(X v

### ^

### -dn

9 1

### + A-V

Equation (21) describes thecyclical behaviorof thetermsof trade as

### a

function ofthe country's industrial structure. It

### shows

that positive country-specific### shocks

to productivity affect negativelytheterms of trade,### and

thiseffectis larger (in### adlnT

absolute value) the richer is the country, i.e. is negative

### and

dn=o ad(Tt-n)

decreasing in x. Equation (21) also

### shows

that positiveglobal### shocks

to productivity### worsen

the termsof trade of poor countries### and

improve thoseof rich countries, i.e. ~\f-iI—### T

is negative if

### x<v

### and

positive ifx>v. Finally, Equation (21)### shows

thatd(n-n)=0

### adn

interest-rate shocks

### have no

effects### on

theterms of trade.### We

discusstheintuitionbehind these results in turn.

Country-specific

### shocks

to productivity### have no

effecton import prices### because

countries are small. But they### do

affectexport prices. Consider a positive country-specific### shock

to productivity. In the a-industry, firms react to the### shock

by producing### more

of### each

variety they### know

### how

to produce. Sincethis set is small, the increase inthe production of### each

varietyis large. Since domestic### and

foreignvarietiesare imperfect substitutes, the increase in production lowers the price ofthe country's a-products. Inthe P-industry, firms

### know

### how

to produceall varieties.### They

react tothe### shock

byspreading their production### among

a large### number

ofvarieties(or byforcing

### some

firms abroad to### do

this).### As

a result, the increase in the production of### each

varietyis infinitesimally small### and

theprices of the country's p-products are not affected. In the aggregate, theterms of trade### worsen

as a result ofthe shock. But if the

### asymmetry

in theelasticity of product### demand

is important, the termsof trade shoulddeteriorate### more

in rich countries.Global shocks influence all countries equally and, consequently, they

### do

not affect the prices ofdifferentvarieties of a-### and

P-products relativeto theircorresponding industryaggregates. Consider a positive global

### shock

to productivity.### We

### saw

earlierthatthis### shock

lowers the price of all (3-products relative to alla-products

### (See

Equation (11)).### The

reason is simple: In both industries, the increasein productivity leads to a directincrease in production. But if the

### asymmetry

in theelasticity ofthe labour supply is important, the increase in productivity raises

### employment

of unskilled workers### and

leads to afurther increase in theproduction of(3-products.

### As

theworld supplyof (3-products increases relative to that of a-products,their relativeprice declines. This is

### why

theterms oftrade of net exporters of|3-products, x<v, deteriorate, while theterms oftrade of net importers of p-products, x>v, improve.

Finally, Equation (21) states that country-specific interest-rate

### shocks

### have no

effects

### on

theterms oftrade.### These

### shocks

### do

not affect import prices### because

the country issmall. Butthey### do

not affect export prices either.### As

discussed earlier,interst-rate

### shocks

### do

not affect the production of a-products.### As

a result, they### do

not affect theprices ofdomesticvarieties relativeto the industryaggregate. Interest-rate### shocks

affect the production of (3-products.### However,

firms in the p-industrycannot### change

their prices intheface of perfectcompetition from firms abroad.Therefore, country-specific### monetary

### shocks

### do

notaffect the termsof trade.Equation (21)

### makes

clear### how

thetwo industry### asymmetries

### shape

thecyclical behaviorofthe terms oftrade. Inthe

### absence

of### asymmetries

in the elasticityofthe labour supply,

### A—

>0, only country-specific### shocks

affectthe### terms

oftrade. Inthe

### absence

of### asymmetries

in the elasticityof product### demand,

8-^°=, only global### shocks

affect theterms of trade. This### has

implications forthevolatility### and

### comovement

graphs fortheterms of trade. Let### V

T(fi,5,Tr,K,i)### denote

the standard deviation of the(detrended) growth of termsof trade of a (|a,8,7t,K,i)-country,### and

let### C

J(\i,5,n) denote its correlation with world### average

### income

growth. Using Equations(22)

### V

T### =a-.

(23)### C

T = (1-il)+ V### (x-v)-A

1### +

### A.v

Tl "l### +

### X-v

### V?

### 'ix-v)X^

### fl-<1-1>

### +

1### +

### X-v

•Tl### To

understandthe intuition behind theseformulae, it is useful toconsidertwo### extreme

cases. Both are illustrated in Figure 4, which plots the volatility### and

### comovement

graphsof theterms oftrade asfunctions of x, fordifferent parameter values.### Assume

firstthatthe only reason### why

business cycles differacross countriesisthe

### asymmetry

in the elasticityof product### demand,

i.e. A=0.Then,### V

T### =

### —

•### a

_{•y/l-'n}

### and

### C

T

### =

.### The

volatilitygraph is### upward

sloping. Sinceall theG

volatility in prices is

### due

to### changes

in thedomestic varieties of a-products, the terms of trade are### more

volatile in rich countries### where

theshare ofthe a-industry is large.### The

### comovement

graph isflat at zero. Whilethe termsof trade respond onlyto country-specific shocks, world### income

responds onlyto global shocks.### As

a resultboth variablesare uncorrelated.

### Assume

nextthat the only reason### why

business cycles are differentacrosscountries is the

### asymmetry

in the elasticityofthe labour supply, i.e. 0^><». Then, T lx-v|-X i— T 1-1 if x <v### V

=J !cr-AH

### an

d### C

### =

i .### The

volatilitygraph looks like### a

V, with1+

### A.v

[ 1 if x### >

va

### minimum

### when

x=v. Since all the volatility in prices is### due

to### changes

intheaggregate industry prices, theterms oftrade are

### more

volatile in countries### where

the share of interindustrytrade in overall trade is large, i.e. | x-v|is large.### These

are thevery rich