Trade patterns, trade balances and idiosyncratic shocks

International Macroeconomics has long sought an explanation for current account fluctuations that matches the data. The approaches have typically focused on better models and new macroeconomic variables. We demonstrate the limitations of this approach by showing that idiosyncratic shocks are an important cause of macroeconomic volatility even for large countries. When explaining these fluctuations, standard macroeconomic models generally assume that firms are small and that their microeconomic shocks cancel out. We show that the high degree of concentration of bilateral trade flows means that idiosyncratic shocks can have a significant impact on aggregate economic fluctuations. We theoretically develop a descomposition components. Taking the model to data on bilateral trade flows from 1970 to 1997, we find that the most comprehensive macroeconomic model can only account for at most half of the observed variance in trade account volumes of each country. Thus, this paper highlights the importance of considering disaggregated data when modeling the current account.