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GTAP Resource #1468

"On the Robustness of Short Run Gains from Trade Reform"
by Rees, Lucy and Rod Tyers

The long run gains from reductions in distortionary tariffs are robustly positive in neoclassical economies. In the short run, however, depending on the prevailing exchange rate and tax regimes, a combination of producer price deflation and nominal wage stickiness can cause trade liberalisation to be contractionary. Because trade liberalisation, taken alone, reduces the home prices of foreign goods, there is a substitution away from home produced goods and a real depreciation. Under the explicit and de facto fixed exchange rate regimes adopted by many developing countries this necessitates a contractionary producer price deflation. Under the floating exchange rate regimes of the larger industrialised economies, if lost tariff revenue is replaced via a consumption tax increase, contractionary producer price deflation can also occur. This paper examines the implications of these and other policy combinations for the short run gains from trade reform using a comparative static numerical model of a generic, two-sector, “almost small” open economy with asset markets and forward looking agents.

Some details:
In the two-sector Heckscher-Ohlin-Samuelson model, where one industry is protected and production is diversified, the gains from trade liberalisation are robust. This fundamental result is the foundation for most economic intuition about trade liberalisation. The conditions under which it generalises have been explored for extensions to many goods and factors (Ethier), many countries (Balassa, Baldwin), specific factors (Mussa, Krueger) and imperfect competition (Krugman). The emphasis in all this literature is on long run comparative statics. While extensions to the short run have been explored, these have tended to emphasise the tax revenue implications of tariff reductions. They have left key questions, including the effects of real exchange rate changes in the presence of nominal rigidities, unanswered.
To address both the “tax mix switch” and the real exchange rate issue in the presence of rigid nominal exchange rates we construct a model of an “almost small” open economy with two sectors, an independent government with a full raft of tax instruments, inventories, saving and investment, financial assets and non-neutrality of money. The analysis is comparative static with simulations at different lengths of run yielding a variety of possible assumptions about forward-looking behaviour of investors and in the consumption-savings decision.
The results map the sensitivity of the contractionary effects of trade reform in the short run, when the nominal exchange rate is fixed, to the degree of nominal wage stickiness, investment responsiveness to expected returns, sectoral similarity, trade openness, capital mobility, inventory responsiveness and the structure of the general tax regime. All these are found to matter, with nominal wage rigidity the key determinant. The more flexible are wages, the more allocative efficiency effects are likely to dominate.
The paper is inspired by broader comparative static modelling results from Macro-GTAP on the short run effects of trade reform in China. These show that the real depreciation accompanying recent trade reforms, combined with the rigid nominal exchange rate regime had considerable effects on overall economic performance (Rees and Tyers). In particular, it is shown that one effect was to retard rural-urban migration, leading to a build-up of underemployed rural workers (Chang and Tyers).

References – reviewed related work:

Chang, J. and R. Tyers, “Trade reform, macroeconomic policy and sectoral labour movement in China", Chapter 14 in Garnaut, R. and L. Song (eds.) China 2003: New Engine for Growth, Asia Pacific Press, September 2003: 231-275.

Rees, L. and R. Tyers, “Trade reform in the short run: China’s WTO accession”, Journal of Asian Economics 15(1), January-February 2004.

Resource Details (Export Citation) GTAP Keywords
Category: 2004 Conference Paper
Status: Published
By/In: Presented at the 7th Annual Conference on Global Economic Analysis, Washington DC, USA
Date: 2004
Created: Tyers, R. (4/30/2004)
Updated: Bacou, M. (6/5/2004)
Visits: 1,893
No keywords have been specified.

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