Wednesday, January 30, 2013

Comovement in business cycles and trade in intermediate goods

NIPFP Working Paper 116

Madhavi Pundit
January 2013


Positive correlation between intermediate goods trade and business cycle comovement raises the question of causality. Existing theories propose the direction from trade to comovement, but don't explain positive correlation of trade with TFP comovement, also in the data. My model predicts both positive correlations, and explains potential causality in the reverse direction, i.e. countries might choose trade partners based on business cycle properties. There is greater benefit in trading with positively correlated sources and self-insuring through capital accumulation, when constrained by domestic technology. I provide empirical evidence of this condition by estimating the elasticity of substitution between capital and intermediates.