Can Trade Theory Help Us Understand the Linkages Between International Trade and Business Cycles?

It is widely accepted that international trade is an important force transmitting business cycles from one country to another. Metaphors such as "when the U.S. sneezes, Europe catches a cold" are often invoked to illustrate the importance of these linkages. Recent empirical research has re-visited this issue, and has indeed found that pairs of countries that trade heavily with each other tend to have highly correlated business cycles. Considering that these findings have important implications for many policy-related issues, including the optimal currency area criteria, it is important to tie them to an analytical framework in which the dynamic linkages between trade and international business cycle co-movement can be studied. We begin by examining whether the findings can be generated by existing international business cycle models. We calibrate and simulate many plausible parameterizations of the workhorse two-good model, but we cannot replicate the empirical results. In an environment with integrated asset markets, increased trade linkages lead to increased "resource-shifting" from one country to another in response to shocks such as productivity shocks. This imparts lower business cycle co-movement. An environment with zero international asset markets can replicate the qualitative dimension of the findings, but falls well short of matching the magnitudes. A key weakness of the existing international business cycle models is that the specialization pattern is hard-wired into the model: Spain makes fruits and nuts, and Germany makes automobiles, period. However, we know from trade theory that specialization patterns change in response to increased international integration of goods and services markets. In fact, it has been argued that because classical (Ricardo, Heckscher-Ohlin) trade theory implies that increased integration leads to increased specialization, business cycle co-movement should be lower. On the other hand, if specialization becomes more intra-industry oriented, so that Spain enters the automobile industry by assembling vehicles, and Germany now produces only auto parts, then presumably business cycle co-movement would increase. Formalizing this intuition, we build an international business cycle model in which specialization is determined according to Ricardian trade theory. Our model allows for both inter-industry and intra-industry specialization. We verify that if increased trade induces significant intra-industry specialization, then the implied increase in business cycle co-movement can quantitatively match the existing empirical findings. We conclude that in order to understand the linkages between international trade and business cycles, it is necessary to take into account the evolving patterns of specialization.