Trade in Capital Goods and Investment-Specific Technical Change

This paper studies the role of trade in capital goods and investment-specific technical change in the determination of the cross-country correlation of output and the volatility of the terms of trade. The cross-country correlation of output for G7 countries ranges from 0.42 to 0.85 and the relative volatility of the terms of trade ranges from 1.24 to 6.06. The standard model with total factor productivity change and trade in final goods only generates a cross-country correlation of 0.05 and a volatility of 0.68. Models that allow trade in capital goods and investment-specific technical change produce a cross-country correlation of at least 0.47 and a volatility of at least 3.86.