The Dynamics of the Trade Balance and the Real Exchange Rate: The J Curve and Trade Costs?

We show that flexible and sticky price multi-country models generate a counterfactual comovement between the trade balance and the real exchange rate and that the dynamics of the US trade balance since 1980 are mostly attributed to declines in trade costs and a gradual response of trade flows to past movements in the real exchange rate. We develop a theoretical model with heterogenous producers, a dynamic export participation decision, pricing to market, and declining trade costs to address these properties of the trade balance. With temporary and permanent shocks to trade costs leading to fluctuations in trade and the observed increases in trade, the model can capture the dynamics of the trade balance and the real exchange rate. With these movements in the trade balance, business cycles are substantially more synchronized and there is much less consumption risk sharing.