Journal Issue
Working Paper Summaries (WP/94/1 - WP/94/76)

Working Paper Summaries 94/5: Comparative Advantage, Exchange Rates, and G-7 Sectoral Trade Balance

International Monetary Fund
Published Date:
August 1994
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This paper investigates the relationship between comparative advantage and sectoral trade balances for the seven major industrial countries (the G-7). It has been motivated in part by the widely-held view that Japan’s sectoral trade balances must be “managed” because Japanese trade is not responsive to normal market forces. This paper uses a Ricardian framework to clarify the role of microeconomic and macroeconomic factors in the time series and cross-sectional behavior of sectoral trade balances. The comparative advantage of the United States and Japan relative to the other G-7 countries is evaluated using relative unit labor costs, and an attempt is made to explain sectoral trade balances. The time series and cross-sectional variation in sectoral unit costs is decomposed into relative productivity, wage differentials, and exchange rate variations.

Japanese productivity has grown rapidly relative to other countries, but it has an unusually high dispersion across sectors. For many sectors, Japan’s productivity in the late 1980s remained well below that of the United States and the G-7 average, but in a few manufacturing sectors Japan was at the top of the G-7 productivity league. U.S. productivity in agriculture and aggregate manufacturing remained well above that of the other G-7 countries. Relative to the aggregate economy, U.S. manufacturing wages were relatively high, while Japanese manufacturing wages tended to be slightly below average, which enhanced Japan’s competitiveness in this sector. Exchange rate changes have played a large role in the medium-term behavior of unit labor costs, especially in the 1980s, when U.S., Japanese, and German competitiveness was strongly influenced by the rise and fall of the dollar.

A statistical analysis finds that changes in the sectoral trade balances are well explained by the evolution of unit labor costs, although the levels of these two variables across countries are sometimes difficult to reconcile because some of the data limitations on trade flows, productivity, and unit labor costs are more acute for assessing levels rather than changes over time. Moreover, it is likely that sectoral nonlabor costs, such as raw materials, vary less over time than across sectors. Except for Canada, the regressions provide some support for the theory of comparative advantage, as sectoral trade balances are usually negatively related to relative unit labor costs. The United States and Japan stand out among the G-7 countries as having sectoral trade balances that are more responsive to sectoral competitiveness over time. Taken together, the regression results indicate that Japan’s trading pattern is explained by the Ricardian model better than the patterns of many of the other countries, contrary to the conventional wisdom that Japanese trade is unresponsive to normal market mechanisms.

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