DP5137 Trade Costs, Trade Balances and Current Accounts: An Application of Gravity to Multilateral Trade

Author(s): Giorgio Fazio, Ronald MacDonald, Jacques Melitz
Publication Date: July 2005
Keyword(s): current account, Feldstein-Horioka puzzle, gravity model, home bias, puzzle, trade balance, trade costs
JEL(s): F10, F32
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5137

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 fundamental revision of Obstfeld and Rogoff?s argument. A further novelty of our work is in tying bilateral trade behaviour to desired aggregate trade balances and desired intertemporal trade.