Trade Costs, Trade Balances and Current Accounts : An Application of Gravity to Multilateral Trade

Fazio, Giorgio and Macdonald, Ronald and Melitz, Jacques (2005) Trade Costs, Trade Balances and Current Accounts : An Application of Gravity to Multilateral Trade. Discussion paper. University of Strathclyde, Glasgow.

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Abstract

In this paper we test the well-known hypothesis of Obstfeld and Rogoff (2000) that trade costs are the key to explaining the so-called Feldstein-Horioka puzzle. Using a gravity framework in an intertemporal context, we provide strong support for the hypothesis and we reconcile our results with the so-called home bias puzzle. Interestingly, this requires a fundamental revision of Obstfeld and Rogoff’s argument. A further novelty of our work is in tying bilateral trade behavior in a world of multiple countries to desired trade balances and desired intertemporal trade.

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