Unifying Macro Elasticities in International Economics

Abstract

International trade studies have higher macro (Armington) elasticity measures compared to international finance studies. This observation has evoked not only mixed policy implications regarding tariffs and exchange rates but also mixed welfare gains from trade. Regarding the policy implications, this so-called international elasticity puzzle is solved in this paper by distinguishing between elasticities of substitution and price elasticities of demand that are connected to each other through expenditure shares. It is shown theoretically and confirmed empirically that the macro elasticity in international trade is a weighted average of the macro elasticity in international finance and the elasticity of substitution across products of foreign countries. It is implied that one can always find an elasticity of substitution across foreign countries that would be consistent with different macro elasticities in the two literatures; therefore, the puzzle is something artificial due to the way that the foreign products are aggregated at destination countries. Regarding the welfare gains from trade, the two literatures are shown to have the very same implications when international finance studies have a unitary macro elasticity of substitution between home and foreign products or unitary terms of trade. As opposed to the existing literature that has offered many supplyside solutions to the puzzle, the results in this paper are independent of the supply side and thus are consistent with any production structure.