Trade in capital goods and the volatility of net exports and the terms of trade

Abstract

Standard two-country dynamic general equilibrium models grossly underpredict the volatility of net exports and the terms of trade. We analyze whether trade in capital goods (equipment) can explain this failure. Trade in equipment accounts for about half of the trade balance of G7 countries and most of its fluctuations over the 1971–1990 period. Simulation results show that a standard model with trade in final goods generates a volatility of 0.10 for net exports and 0.52 for the terms of trade, while the annual G7 median relative volatility are 0.60 and 2.18! Models with trade in equipment, however, generate a volatility between 0.55 and 0.98 for net exports and between 1.23 and 3.24 for the terms of trade.