DP3259 | Trade Openness and Investment Instability

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In the presence of lumpy adjustment costs of investment, globalization may have non-conventional effects on the level of investment and its cyclical behaviour. Free trade may lead to a discrete ?jump? in the level of investment, as it triggers discrete terms-of-trade changes which either appreciate or depreciate the setup cost of investment. As a result, the economy may alternate between ?optimistic? and ?pessimistic? expectations and self-validating boom and bust investment cycles. There could be substantial gains from globalization in the investment-boom equilibrium and meager, or negative, gains in the investment-bust equilibrium.