A Stochastic Dynamic Model of Trade and Growth: Convergence and Diversification

There is a growing literature that studies the properties of models that combine international trade and neoclassical growth theory, but mostly in a deterministic setting. In this paper we introduce uncertainty in a dynamic Heckscher-Ohlin model and characterize the equilibrium of a small open economy in such an environment. Our results differ from the deterministic models in several dimensions. We show that, when trade is balanced period-by-period, the per capita output and consumption of a small open economy converge to an invariant distribution that is independent of the initial wealth. Further, at the invariant distribution, there are periods in which the small economy diversifies. In this setting, when economies diversify, factor price equalization holds only in expected terms. The paper highlights the role of market incompleteness, as a result of the period-by-period trade balance, in achieving our results through an analytical example. Further, numerical simulations show that the speed of convergence increases with the size of the shocks.