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I would like to thank Dave Backus, Guillermo Calvo, Peter Clark, Harold Cole, Jeremy Greenwood, Jonathan Ostry, Assaf Razin, Carmen Reinhart, Lars Svensson, and Linda Tesar for helpful comments and suggestions. This paper reflects only the author’s views and not those of the International Monetary Fund.
Three classic articles discussing the Harberger-Laursen-Metzler effect from the perspective of intertemporal equilibrium models are Obstfeld (1983), Svensson and Razin (1983), and Persson and Svensson (1985).
For a thorough review of the literature on income elasticity of imports see Goldstein and Khan (1985).
Mendoza (1991b) analyzes the role of terms-of-trade disturbances as a driving force of business cycles in industrialized and developing countries using a model of a small open economy with two production sectors and consumption of exportables, importables, and nontradables.
The model presented in the paper focuses on the case of a small open economy, and hence stylized facts for countries such as the United States, Germany, and Japan must be interpreted with caution.
Japan’s fuel imports in 1988 were 27 percent of all imports, while for the rest of the G-7 the share of fuel imports in total imports was between 5 percent and 13 percent.
According to Esptein (1983), the functions u(·) and v(·) should satisfy the following conditions:
u(·)<0, u′(·)>0, u′(0)=∞, ln(-u(·)) convex, and v(·)>0, v;′(·)>0, v′′(·)<0, and u′(·)exp(v(·)) nonincreasing.
The stochastic equilibrium process of the real exchange rate E is given by (pn)ωn, where ωn is the weight of nontradables in the domestic economy’s price index. This requires that purchasing power parity holds for tradable goods and that the relative price of nontradables abroad is nonrandom.
These authors estimated the standard deviation of the world’s expected real interest rate (rwe) at 1.5 percent. The correlations between ey and er, and eP and er were approximated with estimates of the correlation between rw e and the investment-output ratio, and the negative of the correlation between rwe and the price of oil, obtained with the regression coefficients of the corresponding variables in Column (1) of Table 2 and the standard deviations in Table 1 of their paper.
Stockman and Tesar (1991) use a sample that includes 17 developing countries. Their point estimate of the elasticity of substitution is 0.44 with a standard error of 0.225.
Given that Canada’s relatively large and negative ɸ dominates the average for the G-7, ɸ is set at zero for purposes of the simulation analysis so that it reflects more closely the typical ratio of net factor payments to GDP in industrial countries.
Table 4 presents statistical moments for deviations from trend in real net factor payments and real GDP measured at import prices. These variables are proxies for err*a and ey(pxX+pnN) in the model. Notice that with output measured at import prices, the trade balance becomes weakly procyclical instead of countercyclical as in Table 1.
Note that the definition of the trade balance in the model would include trade in merchandise as well as nonfactor services, whereas the measure of the trade balance taken from the balance of payments for the empirical analysis only includes merchandise trade.
Backus, Kehoe, and Kydland (1991b) make a similar argument for the case of a two-country model with complete insurance markets.
Recall from Section II that, excluding durables, the variability of consumption relative to the variability of output is between 0.3 and 0.9 and the GDP correlation of consumption is between 0.6 and 0.8.
This elasticity of imports (im) with respect to GDP (y) is estimated as ρim,y, (σ im/σy [E(im)/E(y)].
Cross-correlations between the trade balance and the terms of trade for the G-7 computed using the data employed to produce the moments in Table 1 also support this argument.
In this context the inability of the barter economy to mimic the countercyclical trade balance is irrelevant, since Mendoza (1991a) shows that in a one-good model with investment the trade balance is countercyclical.
In Stockman and Tesar (1991) and Backus, Kehoe, and Kydland (1991b) the terms of trade are the inverse of the measure used in this paper. Thus, the correlations between the trade balance and the terms of trade that appear in their papers have the opposite signs from those referred to in the text.