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Terms of Trade, Catch-up, and Home Market Effect: The Example of Japan

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Urban, Dieter M.

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Abstract

This paper explores theoretically and empirically the long run relation of the terms of trade (ratio of domestic and foreign prices of traded manufacturing goods) and economic growth of a pair of industrialized countries, one of which experiences a major catch-up process towards the other. It is shown theoretically that there is no mean reversion of the terms of trade towards PPP during a catch-up process, which suggests very long half-life times of terms of trade. Two theoretical interdependencies between the terms of trade and economic growth are offered: the home market effect and the productivity shock effect. These two effects are tested against each other in a cointegration analysis for Japan and the US from 1957 until 1997. Income appears to be a relevant variable to explain the terms of trade in the Post-Bretton-Woods era. The relevant empirical channel is the home market effect. However, financial market effects appear also to be relevant.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number CESifo Working Paper No. 2164.

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Date of creation: 2007
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Handle: RePEc:ces:ceswps:_2164

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Keywords: convergence; real exchange rates; PPP; terms of trade; cointegration;

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