Productivity, Trade, and Relative Prices in a Ricardian World

In an extended Ricardian model of trade, we study the effects of improving trade deficits on relative prices, and the relation between productivity improvements and real exchange rates. An improvement in the trade balance induces relative wages to overshoot their long-run value, placing downward pressure on the terms of trade of the same order of magnitude found in Armington type models. Once the pattern of specialization changes, some of the decline is reversed with a smaller value of depreciation. We find that persistent productivity differentials do not cause distinct trends in the terms of trade. The result depends on the size of the non-tradable sector and the variability of industry-specific efficiencies. We also find that self-selection into export markets causes the relative price of non-tradable goods to respond to exogenous shift, giving birth to an endogenous Balassa-Samuelson effect. The model also suggests that in the long-run the variation of the real exchange rate is dominated by the volatility of the terms of trade.