Two of the effects imply increased volatility, while the other leads to a reduction. Adding
up the three effects, we obtain the overall change in aggregate volatility as implied by equa-
tion (10) of ∆σA2 ≈ 0.0016, or about 19% of average variance of the manufacturing sector
observed in our data over the sample period, 1970-99.
The previous exercise was informative of the kind of differences in aggregate volatility
we can expect from the dispersion of trade openness found in the cross section. That is, we
computed the expected differences in volatility as a function of differences in trade openness
across countries. Alternatively, we can ask how the increase in trade over time within our
sample period is expected to affect aggregate volatility. To learn this, we calculate the mean
difference in the total trade to manufacturing output between the 1970s and the 1990s in
our sample. It turns out that trade openness increased by about 30 percentage points over
the period, going from below 60 percent in the 1970s to 90 percent in the 1990s. The change
in trade openness of this magnitude implies an estimated increase in aggregate volatility of
roughly 0.001. Since in this calculation we are using the same mean values of σ2, ρ, h, σA- ,
and the same βbσ , βbρ , and βbh , the relative importance of the three effects is the same as in
the first exercise: the sectoral volatility effect raises aggregate volatility by about 0.0006,
the comovement effect lowers it by -0.0002, and the specialization effect raises it by about
0.0007.
How sizeable is this effect? Relative to what we observe in the cross section, this
implied change in volatility is equivalent to 12 percent of the average aggregate variance in
our sample. Alternatively, we can also ask how it compares with the changes in aggregate
volatility which occurred between the 1970s and the 1990s. It turns out that on average,
aggregate volatility has decreased by 0.0035 over this period. By this metric, the implied
increase in volatility of 0.001 due to growing trade is equivalent to more than a quarter of
the observed decrease in aggregate volatility. Trade has therefore counteracted the general
tendency of the smoothing out of business cycles over time.21
4.2 Country Characteristics and the Impact on Aggregate Volatility
The two calculations above imply that the average effect of trade openness on aggregate
volatility acting through the three channels is appreciable but modest. However, these are
based on sample averages of σ2, ρ, h, and σA-, and clearly the estimated impact of trade
will differ depending on these country characteristics. For instance, the sectoral volatility
effect would be significantly less important in a highly diversified economy (low h), while
the comovement effect will be magnified in a country with a high volatility (σ2 and σA-).
21See Stock and Watson (2003) for evidence on the fall in volatility in the U.S. and Cecchetti, Flores-
Lagunes and Krause (2006) for cross-country evidence.
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