Trade agreements and international comovements: The case of NAFTA (North American Free Trade Agreement)

Business cycles correlation between Mexico and the US changed from being on a downward sloping path before 1992 to an upward sloping path after that. This paper suggests that the North American Free Trade Agreement could be the explanation. NAFTA generated not only an increase in the volume of trade but also a change in the elasticity of substitution between imports and exports. The paper tests this hypothesis using the neoclassical business cycles model. Although there are still some discrepancies between the theory and data in the degree of correlation, the direction of change in the model corresponds to the one in the data.

► The comovements between the US and Mexico increased after signing NAFTA.
► NAFTA changed the composition of trade between the US and Mexico.
► Elasticity of substitution between imports and exports falls if trade costs fall.
► In the model a reduction in trade cost increases the comovements.
► A change in TFP improves the results but there is no evidence for such a change.