The cost of adjustment: On comovement between the trade balance and the terms of trade

The S-shaped cross-correlation function between the trade balance and the terms of trade has been documented for several countries and time frames. The ability of two-country, two-good business cycle models to reproduce this regularity hinges on the dynamics of capital formation. We consider the consequences of modeling the adjustment costs for comovement in the trade balance and the terms of trade. Both complete and incomplete market models with capital adjustment costs à la Hayashi (1982) deliver the S-curve seen in the data while the model with investment adjustment costs à la Christiano et al. (2005) does not.