Puzzles in international macroeconomics

Six major puzzles in international macroeconomics: search for a common cause Obsteld M. and K. Rogoff,  The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?, 2000, NBER Working paper 7777. Home bias in trade Saving-investment puzzle Equity home bias Consumption correlation puzzle Purchasing Power Parity Exchange rate disconnect

By explicitly introducing trade costs, one can go far toward explaining a great number of the main empirical puzzles. Trade costs may include transportation costs, tariffs, non-tariff barriers

Home bias in trade International markets are more segmented then is commonly supposed There is a substantial border effect that reduce cross-country trade How big is the border effect? Can the market segmentation be explained by trade costs of the reasonable size?

How big is the border effect? McCallum 1996, National Borders Matter: Canada-US regional trade patterns, American Economic Review 85, pp. 615-623

Trade across individual Canadian provinces was 22 times higher then between individual Canadian provinces and US states!

Is anything wrong with McCallum’s estimation of the border effect Asymmetric effect on countries of different size Misspecification of the gravity equation Anderson and Wincoop (2003), Gravities with Gravitas: A solution to the Border puzzle, American Economic Review 93, pp. 170-192 National borders reduce trade between the US and Canada by about 44%, while reducing trade among other industrialized countries by about 30%. McCallum's spectacular headline number is the result of a combination of omitted variables bias and the small size of the Canadian economy. Within-Canada trade rises by a factor 6 due to the border. In contrast, within-US trade rises 25%.

Asymmetric effect on countries of different size: numerical example With no trade barriers, Canada exports 90% of GDP to the US and sells 10% internally Suppose the border effect reduces cross-border trade by 50% Then, Canada imports 45% of GDP to US and trade 55% internally So, internal trade went up by 5.5 times, cross border trade went down by 50%, and so internal trade has increased by 11 times more then cross-border trade For US, it used to import 10% of GDP and now imports 5%. Cross-state trade has increased by 2.1 times more then cross-border trade

Home bias in trade Obstfeld, Rogoff 2000: Average size trade costs combined with high elasticities of substitution of home for foreign goods can account for large part of home bias In addition, exchange rate uncertainty and difference in tastes across countries also leads to higher home good consumption

Empirical estimates of θ Trefler and Lai (1999) θ=5.2 panel of 28 industries in 36 countries for the period 1972-1992 Cheung, Finn, and Fujji (1999): θ=3.5-4 monopolistic competition model two-digit industry level data for OECD countries Hummels (1999a): θ=5.6

Empirical estimates of trade costs

Saving-investment puzzle Feldstein, Martin, and Charles Horioka (1980) “Domestic Savings and International Capital Flows,” Economic Journal 90 (358) June, 314-329. Correlation between savings and investments in OECD countries is much greater then predicted by economic models

Equity home bias Equity home bias (Kenneth R. French; James M. Poterba, (1991), Investor Diversification and International Equity Markets The American Economic Review, Vol. 81, No. 2.) Economic agents prefer to keep their wealth in home assets. They diversify their portfolio less then predicted by models of risk-sharing and are overly optimistic about returns on home assets At the end of the 80th, Americans held 94 percent of their wealth in the US stock market, whereas Japanese held 98 percent of their equity wealth at home

Consumption correlation puzzle Consumption correlation puzzle (Backus, Kehoe, and Kydland 1992, International Real Business Cycles, Journal of Political Economy 100, pp. 745-775 ) International output growth rates are more highly correlated then consumption growth rates

Purchasing Power Parity Purchasing Power Parity (Rogoff, Kenneth (1996), “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, Vol.34, No. 2., pp. 647-668.) Does not hold in a short run, there are some evidence that it holds over the long horizon

Exchange rate disconnect Exchange rate disconnect (Baxter, M and A. Stockman, 1989, Business Cycles and Exchange Rate regime: some international evidence, Journal on Monetary Economics, 23, pp. 377-400) Weak connection between exchange rates and virtually any macroeconomic aggregates