Journal Issue

Research: Exploring the Costs and Benefits of Trade Liberalization

International Monetary Fund. External Relations Dept.
Published Date:
May 2006
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Trade policy, immigrants’ labor market performance, and the benefits of trade liberalization were among the topics discussed at an April 13 conference on international trade sponsored by the Trade and Investment Division of the IMF’s Research Department. The event, the third in a series, drew researchers from inside and outside the Fund and was designed to deepen participants’ understanding of the patterns and economic implications of various international flows of goods and capital.

The conference led off with Andrei Levchenko (IMF) presenting “Openness, Volatility, and the Risk Content of Exports,” a study he coauthored with Julian di Giovanni (IMF). Motivated by the observation that countries that are more open to trade experience higher volatility of output growth, they used an industry-level panel data set of manufacturing production and trade to analyze the mechanisms through which trade can affect the volatility of production. Their findings indicated that sectors that trade more are more volatile and that trade leads to increased specialization. These two forces increase overall volatility.

Levchenko and di Giovanni also found that output in sectors that are more open to trade is less correlated with output in the rest of the economy, a factor that reduces aggregate volatility. They showed that each of the three factors has an appreciable effect on aggregate volatility. When the three effects are combined, they imply that a one-standard-deviation change in trade openness is associated with an increase in aggregate volatility of about 15 percent of the mean volatility observed in the data. The authors used these results to provide estimates of the welfare cost of increased volatility under several sets of assumptions. Finally, they developed a summary measure of the riskiness of a country’s pattern of export specialization and analyzed its features across countries and over time. The risk content of countries’ exports varies greatly but does not have a simple relationship to the level of income or other country characteristics.

A country’s trade pattern is, of course, often heavily influenced by the domestic political process. Professor Doug Nelson (Tulane University and IMF Visiting Scholar) and Carl Davidson and Steve Matusz (both of Michigan State University) examined the issue of perceived fairness and its relation to trade policy in “Fairness and the Political Economy of Trade.” They argued that, as a matter of positive political economy, fairness plays a nontrivial role in the politics of trade policy. Widely held notions of fairness, which are identifiable at the micro level, have macro effects not only on a country’s social and political systems but also on the economy. They went on to argue that these notions systematically constrain public officials in formulating and pursuing trade policy.

Paradox of international capital flows

Shifting to the topic of capital flows, Professor Jiandong Ju (University of Oklahoma and IMF Visiting Scholar) and Shang-Jin Wei (IMF) confronted two issues in international economics in their study “A Solution to Two Paradoxes of International Capital Flows.” Depending on the model used, international capital flows from rich to poor countries can be regarded as either too small (the Lucas paradox in a one-sector model) or too large (when compared with the logic of factor price equalization in a two-sector model).

To resolve the paradoxes, the authors proposed a non-neoclassical theory that marries a model of financial contract between entrepreneurs and investors conceived by Holmstrom and Tirole (1998) with the Heckscher-Ohlin-Samuelson framework. In their model, the return to financial investment and the marginal product of physical capital are naturally separate. The model generated a number of interesting predictions that seem to fit the data well. For example, between rich and poor countries, there can be massive, two-way gross capital flows but only a small net flow. In fact, in the unique equilibrium in the world capital market, the relatively inefficient financial system is completely bypassed.

Few other international organizations evoke more diverse sentiments than the World Trade Organization (WTO) or its predecessor, the General Agreement on Tariffs and Trade (GATT). Although entry to the world trade body is often regarded as a stepping-stone in a country’s economic ascent, many people believe their welfare is unfairly squeezed by the organization’s promotion of globalization. Others, between the two extremes, doubt that this organization really matters.

In their paper, “Is Bitter Medicine Good for You? The Economic Consequences of WTO/GATT Accessions,” M.K. Tang (IMF) and Shang-Jin Wei addressed the debates about the value of WTO/GATT membership. They showed that countries acceding to the WTO/GATT during and after the Uruguay Round tended to experience a significant increase in economic growth and the investment-to-GDP ratio around the time of their accession. Countries that did not undergo rigorous accession procedures, however, did not seem to derive any beneficial effects. Moreover, Tang and Wei offered evidence that accession-induced policy commitments benefit the acceding countries, especially those that scored low on the governance quality index. Overall, the paper suggested that the policy reforms associated with WTO/GATT accession spurred a country’s economic performance.

People on the move

Besides goods, services, and physical capital, there are also significant cross-border movements of people (human capital). In presenting their joint study “Brain Waste? Educated Immigrants in the U.S. Labor Market,” Caglar Ozden, Aaditya Mattoo, and Ileana Cristina Neagu (all of the World Bank) focused on these international movements and investigated the occupational destinations of individuals immigrating to the United States. They found that immigrants of similar age, education level, and work experience but having different countries of origin tend to end up with very different occupations. For instance, educated Latin American and Eastern European immigrants are more likely to be employed in unskilled occupations than immigrants from Asian and developed countries.

Their findings suggested that two forces are at play in shaping the immigrants’ labor market performance. First, the quality of human capital, influenced by how much immigrants’ countries of origin spent on tertiary education and whether English was used as a medium of instruction, is an important factor. Second, because of the relative difficulty of migrating to the United States from many Asian countries, especially relative to Latin America, only the more skilled college graduates are likely to come and their performance is likely to be higher.

The conference ended with a quantitative assessment of the benefits of trade liberalization. Although it is commonly believed that openness to trade leads to increased efficiency, countries are often put off partly by the short-term mac-roeconomic adjustment costs that can be associated with trade liberalization. In the paper “Trade Liberalization, Macroeconomic Adjustment, and Welfare: Unifying Trade and Macro Models,” Ehsan Choudhri (Carleton University) and Hamid Faruqee and Stephen Tokarick (both of the IMF) argued, by means of a dynamic general equilibrium model, that the short-term adjustment costs are small compared with the long-term gains in efficiency. Their model also showed that adjustment costs tend to be even lower under flexible exchange rates or an interest rate rule that targets flexible price levels. Their results thus not only pointed to the desirability of trade liberalization but also offered constructive suggestions about how to magnify the overall liberalization benefits through appropriate exchange rate and monetary policies.

Phil McCalman and M.K. Tang

IMF Research Department

The full texts of the papers are available on the IMF’s website (

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