INTERPRETING COMOVEMENTS IN THE TRADE BALANCE AND THE TERMS OF TRADE

I examine the relation between the trade balance and the terms of trade in a two-country dynamic stochastic exchange economy with complete markets. Along an equilibrium path for this economy, the relation is governed by the substitutability between foreign and domestic goods. I find, in contrast to non-stochastic analyses of the Harberger-Laursen-Metzler effect, that a positive association does not require persistent shocks or non-constant rates of time preference. This contrast highlights the role played by the structure of asset markets, complete and otherwise, in generating equilibrium comovements.