Dynamic Aspects of Productivity Spillovers, Terms of Trade, and the “Home Market Effect”

Recent empirical findings conclude that the terms of trade improve even after the positive productivity shock hits the economy among advanced economies. Corsetti, Martin, and Pesenti (2007), henceforth CMPs analytically show that a static two-country model with endogenous firm entry can generate improvement of the terms of trade in response to a positive technology shock in the form of lowering the entry cost. This paper evaluates the robustness of the results in CMP in a model with richer and more realistic dynamics such as nominal price and wage stickiness as in the Global Economy Model. It shows how the economic variables respond to the shocks that shift the production frontier outward, namely, productivity gains in manufacturing and efficiency gains in creating new firms. The main conclusions are that short-run responses could be different from those in CMP because of the existence of real as well as nominal rigidities, and that the persistence of shocks also alters the direction of responses via the wealth effect. These results suggest that it is of great importance for policy institutions to acknowledge the dynamic aspects of productivity spillovers by simulating a model with richer dynamics.