A Unified Model of International Business Cycles and Trade

Abstract

We present a general, competitive open economy business cycle model with capital accumulation, trade in intermediate goods, production externalities in the intermediate and final goods sectors, and iceberg trade costs. Our main theoretical result shows that models developed in the modern international trade literature that feature comparative advantage, monopolistic competition and cost of entry, and firm heterogeneity and cost of exporting are isomorphic, in terms of aggregate equilibrium, to versions of this competitive dynamic model under appropriate restrictions on the externalities. In particular, the restrictions apply on the overall scale of externalities, the split of externalities between the different factors of production, and the identity of the sectors with production externalities. Our quantitative exercise assesses whether various restricted versions of the general model, in forms they are typically considered in the literature, are able to resolve the well-known aggregate empirical puzzles in international business cycle models. Our theoretical result on isomorphism between models then provides insights on why they fail to do so in many instances. We thus provide a unified theoretical and quantitative treatment of the international business cycles and trade literatures in a general dynamic framework.