Capital, Finance and International Trade Collapse

This paper proposes a model of international trade with capital accumulation and …nancial frictions. This is achieved by embedding the Melitz (2003) model into an incomplete-markets neoclassical framework with an endogenous credit market. The model preserves the analytical tractability of the original Melitz model. We use the model to examine the di¤erential e¤ects of …nancial and non-…nancial shocks on aggregate output and international trade ‡ows. The model predicts that trade volume declines far more sharply and signi…cantly than that of output (with an elasticity larger than 3) under …nancial shocks than under non-…nancial shocks. The prediction is consistent with the stylized fact that most countries that experienced major …nancial crises had signi…cantly larger and sharper contraction in trade volume than aggregate output (as is also true during the recent …nancial crisis). In the long run, however, a deeper …nancial market raises not only the level of aggregate productivity but also the ratio of trade volume to domestic output.