Trade Wedges, Inventories, and International Business Cycles

By George Alessandria, Joseph Kaboski and Virgiliu Midrigan

The large, persistent fluctuations in international trade that can not be explained in standard models by changes in expenditures and relative prices are often attributed to trade wedges. We show that these trade wedges can reflect the decisions of importers to change their inventory holdings. We find that a two-country model of international business cycles with an inventory management decision can generate trade flows and wedges consistent with the data. Moreover, matching trade flows alters the international transmission of business cycles. Specifically, real net exports become countercyclical and consumption is less correlated across countries than in standard models. We also show that ignoring inventories as a source of trade wedges substantially overstates the role of trade wedges in business cycle fluctuations.

Interesting how including inventory management can fix things in international business cycle models. Inventories are held by domestic retailers, who must hold stock before selling (obviously) but also before learning about shocks. Excess inventory can only be returned after one period. This means there are only stocks of imports and domestic goods, but never inventories of export goods. I wonder whether the data yields this, and whether it matters. It should at least for the cyclicality of net exports, because if exporters also have to play the game of expectations about future demand, import inventories become less important in the model.

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