Working Paper: CEPR ID: DP11014
Authors: Paolo Epifani; Gino Gancia
Abstract: We study the welfare effects of trade imbalances in a two-sector model of monopolistic competition. As in perfect competition, a trade surplus involves an income transfer to the deficit country and possibly a terms-of-trade deterioration. Unlike the conventional wisdom, however, trade imbalances do not impose any double burden on surplus countries. This is because of a production-delocation effect, which leads to a reduction in the local price index. In the presence of intermediate goods, new results arise: A trade surplus may lead to an appreciation of the exchange rate, to a terms-of-trade improvement and to a welfare increase under standard parameter configurations. In addition, policies that stabilize the exchange rate can make the balanced-trade equilibrium unstable. These results can explain why the manufacturing sector may agglomerate in countries that resist the real appreciation of their currency and suggest that a fixed exchange rate and nominal rigidities may generate short-run instability.
Keywords: Intermediate goods; Monopolistic competition; Trade costs; Trade imbalances
JEL Codes: F1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| trade imbalances (income transfers) (F16) | local price indexes (P22) |
| trade imbalances (income transfers) (F16) | welfare outcomes (I38) |
| increase in number of manufacturing firms (L60) | local price index (P22) |
| local price index (P22) | competitiveness of manufacturing firms in surplus countries (F14) |
| trade surplus (F14) | appreciation of exchange rate (F31) |
| trade surplus (F14) | improvement in terms of trade (F14) |
| policies stabilizing the exchange rate (F31) | destabilize balanced trade equilibrium (F41) |
| trade imbalances (F14) | international location of manufacturing firms (F23) |