The cost of adjustment: On comovement between the trade balance and the terms of trade

a r t i c l e i n f o The S-shaped cross-correlation function between the trade balance and the terms of trade has been documented for several countries and time frames. The ability of two-country, two-good business cycle models to reproduce this regularity hinges on the dynamics of capital formation. We consider the consequences of modeling the adjustment costs for comovement in the trade balance and the terms of trade. Both complete and incomplete market models with capital adjustment costs à la Hayashi (1982) deliver the S-curve seen in the data while the model with investment adjustment costs à la Christiano et al. (2005) does not. 1. Introduction " One of the central questions of international economics concerns the relation between the trade balance and the terms of trade: what features of an economy determine whether an increase in the relative price of imports is associated with improvement or deterioration in the balance of trade? " [Backus, 1993, p. 375] This paper attempts to answer Backus's question by focusing on a single class of frictions commonly used in open economy models. We assess the consequences of modeling adjustment costs to capital accumulation for comovements in the trade balance and the terms of trade. We restrict our attention to two types of functions. Investment adjustment costs (IAC), popularized by Christiano et al. (2005), punish changes in the level of investment. Capital adjustment costs (CAC), described by Hayashi (1982), penalize changes in the capital stock. Most two-country models rely on adjustment costs to capital formation to prevent excessive volatility of investment. This volatility is a consequence of perfect risk sharing. Hence, the benchmark we choose is a two-country, two-good business cycle model with complete markets. (henceforth BKK), adjustment costs to capital formation have been used extensively in the context of international business cycle models. BKK use a " time-to-build " structure, as in Kydland and Prescott (1982), to dampen the volatility of cross-border investment flows in response to location-specific productivity shocks. However, since the publication of Baxter and Crucini (1995), it has been more common to use Hayashi's (1982) convex capital adjustment costs (e.g. Baxter and Farr, 2005; Yakhin, 2007). Alternative specifications of the capital adjustment cost friction have also been used by Kollmann (1996) and Raffo (2008). Several more recent papers rely on investment adjustment costs to match observed investment volatility. For instance, Enders and Müller (2009) use IAC …