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

Author(s): Giorgio Fazio , Ronald MacDonald , Jacques Mélitz

Publication Date: July 2005

Keyword(s): Feldstein-Horioka puzzle , trade costs , gravity model , home bias , puzzle , current account , trade balance

JEL(s): F10 , F32

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5137.asp

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.