Globalization Institute Working Paper
Technology Choice and the Long- and Short-Run Armington Elasticity
Abstract: This paper studies the international transmission of productivity shocks when the Armington elasticity is endogenized through firms' technology choice. With costly adjustment, technology choice allows for a low short-run elasticity and a high long-run elasticity. I provide analytical results which demonstrate how technology choice provides a solution to the Backus-Smith puzzle - the observed negative correlation between relative consumption and the real exchange rate. I then embed technology choice in a quantitative model of international trade with heterogeneous firms and endogenous producer entry. When the cost of adjustment is parameterized to match the correlation between relative consumption and the real exchange rate, the cross-correlation of GDP is higher than the cross-correlation of consumption, thereby providing a solution to the quantity anomaly.