Author(s):	Paolo Epifani, Gino Gancia
Publication Date:	December 2015
Keyword(s):	intermediate goods, monopolistic competition, trade costs, trade imbalances
JEL(s):	F1
Programme Areas:	International Trade and Regional Economics, International Macroeconomics and Finance
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=11014

We study the welfare effects of trade imbalances in a two-sector model of monopolistic competition. As in perfect competition, a trade surplus involves an income transfer to the deficit country and possibly a terms-of-trade deterioration. Unlike the conventional wisdom, however, trade imbalances do not impose any double burden on surplus countries. This is because of a production-delocation effect, which leads to a reduction in the local price index. In the presence of intermediate goods, new results arise: A trade surplus may lead to an appreciation of the exchange rate, to a terms-of-trade improvement and to a welfare increase under standard parameter configurations. In addition, policies that stabilize the exchange rate can make the balanced-trade equilibrium unstable. These results can explain why the manufacturing sector may agglomerate in countries that resist the real appreciation of their currency and suggest that a fixed exchange rate and nominal rigidities may generate short-run instability.