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We are grateful to Andrew Feltenstein, Michael Kumhof, Eswar Prasad, Sunil Sharma, Francis Warnock, and seminar participants at the IMF Institute and the Center for Financial Studies for helpful comments on earlier versions of this paper. The views expressed in this paper are ours and should not be attributed to any organization or institution. We are responsible for any and all errors and omissions.
Although we do not focus on substitutability in this paper, if goods are highly substitutable, then an increase in trade costs will have a lesser effect on relative prices compared to goods that are less substitutable.
Our view is that GDP shares are probably a better proxy for “country size” than population. However, since our empirical investigation focuses only on OECD countries, the distinction is relatively unimportant.
Our results are broadly similar to Crucini (1997), who finds that supply shocks have less impact on consumption and the trade balance for larger countries relative to smaller countries.
The exceptions are foreign liabilities and government expenditures, which have steady-state values of zero. Their deviations are expressed relative to steady-state consumption --
Betts and Devereaux (1996, 2000) achieve a similar result by introducing pricing-to-market. Our results are consistent with Rogoff (1996), who stresses the role of trade frictions in the explaining the dynamic properties of the real exchange rate.
Although several studies have examined the importance of relative shocks, we are not aware of any studies that have documented the importance of individual shocks for any countries.
We chose to limit our analysis to OECD countries both because the model, which is based on monopolistic competition, seems more appropriate for developed countries and because the data is probably better quality for developed countries than for emerging markets.