DP3728 | Heckscher-Ohlin Business Cycles

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We present a neoclassical two-country dynamic trade model in which moderate reductions in trade costs can generate sizable increases in trade volumes over time. In our setup, a fall in trade costs has two effects on the volume of trade. First, for given factor endowments, it raises the degree of specialization of countries, leading to a larger volume of trade in the short run. Second, it raises (lowers) the factor price of each country?s abundant (scarce) production factor, leading to diverging paths of relative factor endowments across countries and a rising degree of specialization. This creates an additional effect on the future volume of trade that adds to the static and dynamic effects of future falls in trade costs. A simulation exercise shows that a fall in trade costs over time produces an exponential increase in the trade share of output, much in line with the data.