RDP 2007-10: Trade Costs and Some Puzzles in International Macroeconomics 7. Conclusions

Using panel data for a set of developed economies, this paper summarises the link between trade costs and three important puzzles in international macroeconomics. It provides evidence that the Feldstein-Horioka saving-investment puzzle and the PPP puzzle are partially explained by trade costs. The signs of coefficient estimates imply that higher trade costs are associated with a stronger relationship between investment and savings and a more persistent exchange rate. The size of the coefficients implies that these effects are economically important, with trade costs accounting for something like half of each puzzle. However, the relationship is generally statistically significant only for the Feldstein-Horioka puzzle. While there is some evidence for a link between trade costs and the consumption correlation puzzle, it is more mixed and trade costs appear to explain little of this puzzle.

Additional analysis suggests that the effect of trade costs is somewhat robust to the inclusion of measures of capital controls in the regressions. Also, it is worth noting that the trade-cost measure used here is likely to be an imperfect measure of actual trade costs and so this approach may understate the relationship between these puzzles and trade costs.

It is important to recognise that, at best, trade costs appear to only explain certain aspects of the puzzles or correlation. Moreover, as there is little evidence of trade costs explaining the consumption correlation puzzle and arguably fragile evidence of it explaining the PPP puzzle, more work needs to be done to understand how trade costs relate to these puzzles. One plausible argument is that all three puzzles should be linked because they are in some sense connected to issues of financial market imperfections. The developing theoretical literature on trade costs and some of the other puzzles in international macroeconomics (such as Coeurdacier 2006) may provide further insights into the nature of the relationships and how to better understand them empirically.