A Gains from Trade Perspective on Macroeconomic Fluctuations

Many modern macroeconomic models either adopt a representative agent setup or introduce heterogeneity among individuals that leads only to trade in assets, while excluding the possibility that agents gain from trading with each other in goods markets. This paper adds the latter aspect into the standard framework by assuming that not all agents are perfect substitutes in the production of goods from different sectors. In other words, not all agents are equally valuable at producing all goods in the short run. Since agents are specialized in the goods they can produce in the short run, this creates a situation where there are explicit gains from trade between individuals.

The baseline model of the paper is a two-sector model, where consumption and investment goods are produced. The main interest lies in knowing when changes in the information set that agents perceive as being relevant for predicting the future may cause booms and busts. An important result of the paper is that when labor in both sectors is perfectly homogeneous, the Walrasian equilibrium of the economy cannot exhibit positive aggregate co-movement, i.e., aggregate consumption, aggregate investment and employment cannot all strictly increase after a positive change in the exogenous component in the agents’ information set. The model with homogeneous labor thus fails to generate one of the well-established features of business cycles. It is shown in the paper, however, that the Walrasian equilibrium of the economy can exhibit positive co-movement, if preferences are identical but labor markets are specialized, i.e., there are explicit gains from trade. In such a setting, perception driven positive aggregate co-movement arises if the market for capital is well-behaved, i.e., aggregate capital supply is upward sloping and aggregate capital demand is downward sloping.

Another focus of the paper is on positive policy analysis. First, the conditions are examined, under which fiscal multipliers can be observed. By looking at fiscal policies which are composed only of current government expenditures paid by current taxes and consist of only the purchase of investment goods by the government, it is shown that an increase in public spending tends to crowd out private expenditures when there are no explicit gains from trade. Allowing explicit gains from trade in the model leads, on the other hand, to the opposite result: an increase in government purchases of capital goods leads to an increase in private purchases of consumption goods and create positive co-movement, while leaving private purchases of capital goods relatively untouched. Second, explicit gains from trade is introduced into a standard sticky price model in order to check how the conventional wisdom regarding the determination of inflation and the role of monetary policy in responding to demand shocks is altered. Thus, a simple mechanism is provided where boom-bust cycles are simultaneously consistent with stable inflation, as has been observed in the last decades in many economies.

Finally, it is examined whether the main assumption of the paper, explicit gains from trade due to the fact that workers are not perfectly mobile across all sectors of the economy in the short run, is supported by the data. Various panel estimations based on PSID data support the assumption.

Beaudry, Paul and Franck Portier (2012), A Gains from Trade Perspective on Macroeconomic Fluctuations, ZEW Discussion Paper No. 12-002, Mannheim.