Trading Costs in IRBC

Backus, D. K.; P. J. Kehoe and F. E. Kydland. 1992. "International Real Business Cycles." Journal of Political Economy

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A surprising feature of these two experiments is that a small trading cost produces most of the properties of autarky. A possible explanation comes from Cole and Obstfeld (1991): if the gains from trade are small, then a small cost may have a large effect on the quantity of trade in goods and assets. To investigate this for our model, we measure the gains from trade by comparing equilibria in the benchmark (free-trade) economy to those in the autarky economy. We express the welfare gain as the percentage increase in the consumption path under autarky necessary to reach the same level of welfare attained with free access to international markets. Welfare in each case is estimated as the mean value of discounted utility over the 50 replications of 100 periods each. We find that consumption in autarky must be increased only 0.3 percent to make consumers as well off as they are when international markets are open. The welfare gains from trade in our theoretical economies stem solely from trade across states and dates. As in similar calculations by Cole and Obstfeld, the gains are remarkably small, which may help to account for the large effect of a small trading cost on the model's equilibria.
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