Macroeconomic volatility and welfare loss under free-trade in two-country models

Abstract

This paper investigates the interlinkage in the business cycles based on sunspot fluctuations of large-country economies in a free-trade equilibrium. We consider a two-country, two-good, two-factor general equilibrium model with Cobb-Douglastechnologies, sector-specific externalities and linear preferences. We also assume constant social returns in the investment good sector but decreasing social returns in the consumption good sector. We first identify the determinants of each country's accumulation pattern in autarky equilibrium, and second we show that some country's sunspot fluctuations may spread throughout the world once trade opens even if the other country has determinacy under autarky. We thus prove that under free-trade, globalization and market integration may have destabilizing effects on a country's competitive equilibrium. Finally, we characterize a configuration in which opening to international trade improves the stationary welfare at the world level but deteriorates the stationary welfare of the country which imports investment goods and exports consumption goods. We thus show that in opposition to the standard belief, international trade may not be beneficial to all trading partners in the long run. Moreover, we prove that for some country, international trade may have contrasted consequences as it may at the same time improve the stationary welfare and have a destabilizing effect