Solving the Elasticity Puzzle in International Economics

Abstract

____________________________________________________________ In models of international trade, the elasticity of substitution between foreign and domestic goods – the Armington elasticity – determines the behavior of trade flows and international prices. International real business cycle models need low elasticities to match the quarterly fluctuations in trade balances and the terms of trade, but static applied general equilibrium models need high elasticities to account for the growth in trade following trade liberalization. To reconcile these contradictory findings, we construct a model in which quarterly fluctuations are caused by temporary shocks, but tariff changes are permanent. In the model, plants do not change export status in response to temporary shocks, while tariff decreases induce some non-exporters to export. In a calibrated model, this entry increases the measured elasticity with respect to a tariff change to 6.2, while the elasticity in response to temporary shocks is 1.4. ________________________________________________________________________ *© 2005, Kim J. Ruhl. I would like to thank Timothy Kehoe for his advice and encouragement. I also thank V.V. Chari, Patrick Kehoe, Sam Kortum, Erzo G.J. Luttmer, Edward Prescott, and the members of the Macro/Trade Workshop at the University of Minnesota. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

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