Does Trade Cause Does Trade Cause Growth?Growth?

JEFFREY A. FRANKEL JEFFREY A. FRANKEL AND AND DAVID ROMERDAVID ROMER**

by by ILKER KAYAILKER KAYA

The big questionThe big question

What is the impact of What is the impact of international trade on international trade on standards of living?standards of living?

Technical ChallengeTechnical Challenge

How are we going to How are we going to measure the effect of measure the effect of international trade on international trade on income (standards of income (standards of living)living)

ProblemsProblems

The trade share may be endogenous: The trade share may be endogenous: countries whose incomes are high for countries whose incomes are high for reasons other than trade may trade reasons other than trade may trade more.more.

There is not enough available dataThere is not enough available data

Why this estimation is Why this estimation is different?different?

In contrast to conventional gravity In contrast to conventional gravity equations for bilateral trade, this equations for bilateral trade, this trade equation includes only trade equation includes only geographic characteristics: countries’ geographic characteristics: countries’ sizes, their distances from one sizes, their distances from one another, whether they share a another, whether they share a border, and whether they are border, and whether they are landlocked. landlocked.

Main assumptionMain assumption

A country’s geographic A country’s geographic characteristics have characteristics have important effects on its important effects on its income through their income through their impact on tradeimpact on trade

We can use geographic We can use geographic characteristic as IV characteristic as IV

becausebecause;; Countries’ geographic characteristics Countries’ geographic characteristics

are not affected by their incomes, or are not affected by their incomes, or by government policies and other by government policies and other factors that influence income.factors that influence income.

The instrument depends only on The instrument depends only on countries’ geographic characteristics, countries’ geographic characteristics, not on their incomes or actual trading not on their incomes or actual trading patterns.patterns.

average income in country i is a function average income in country i is a function ofof

““international trade” and “within-country trade”,international trade” and “within-country trade”,

and other factors:and other factors:

(1)(1) ln ln YYi i == αα + + ββTTi i + + γγWWii + + ЄЄii..

YYi i == income per person, income per person,

TTii = = international trade, international trade,

WWii== within-country trade, within-country trade,

ЄЄi i == other influences on income. other influences on income.

international tradeinternational trade

(2) T(2) Ti i ==ΨΨ + + ΦΦPPi i + + δδii

PPii=proximity to other countries, =proximity to other countries,

δδii= other factors= other factors

within-country trade within-country trade

(3) (3) WWi i = = ηη + + λλSSi i + + ννii

SSii = = the country’s size,the country’s size,

vvii= residuals (other factors)= residuals (other factors)

The residuals in these three equations, The residuals in these three equations, ЄЄii,, δδii and and vvii, are likely to be correlated., are likely to be correlated.

The key identifying assumption of this The key identifying assumption of this analysis is that countries’ geographic analysis is that countries’ geographic characteristics (their characteristics (their P P ’s and ’s and S S ’s) are ’s) are uncorrelated with the residuals(uncorrelated with the residuals(ЄЄ ) in ) in equation equation (1)(1) and correlated with and correlated with T T and and WW

The main equation estimatedThe main equation estimated;;

N =N = population population A A = area= area L L = dummy for landlocked countries= dummy for landlocked countries B B = dummy for a common border = dummy for a common border

between two countries.between two countries.

Results of main Results of main estimationestimation

Distance has a large and overwhelmingly significant negative impact on bilateral trade.

Trade between country i and country j is strongly increasing in j’s size.

If one of the countries is landlocked, trade falls by about a third.

Sharing a border has a considerable effect on trade.

The regression confirms that geographic variables are major determinants of bilateral trade.

Aggregate Trade

ln(דij/GDPi) = a’Xij + eij,

Tˆi = ∑j≠i e aˆ’Xij

estimation of the geographic component of country i ’s trade is the sum of the estimated geographic components of its bilateral trade with each other country in the world.

for all countries, not just those for which we have bilateral trade data

Estimates of Trade’s Effect on Income

ln Yi = a + bTi + c1ln N i +c2ln Ai + ui

Yi = income per person in country i Ti = trade shareN i = populationAi = area

Basic resultsBasic results

The regression shows a statistically and economically significant relationship between trade and income.

Controlling for international trade, there is a positive relation between country size and income per person.

Basic results continuedBasic results continued The coefficient on area is positive. The

reason is sampling error or greater area has a negative impact via decreased within-country trade, but a larger positive impact via increased natural resources.

Using population alone to measure size has no major impact on the results.

Why Are the IV Estimates Greater Than

the OLS Estimates?

The IV estimate is almost always considerably larger than the OLS estimate

There are two leading explanations1. It is due to sampling variation.2. OLS is in fact biased down.

Conclusions Conclusions There is no evidence that the positive

association between international trade and income arises because countries whose incomes are high for other reasons engage in more trade.

The point estimates suggest that the impact of trade is substantial. The ratio of trade to GDP by one percentage point raises income per person by between one-half and two percent.

ConclusionsConclusions Increased size raises income. This

supports the hypothesis that greater within-country trade raises income.

The impacts of trade and size are not estimated very precisely. As a result, the estimates still leave considerable uncertainty about the magnitudes of their effects.

050

100150200250300350400450500

1st Qtr 2ndQtr

3rdQtr

4thQtr

TradeGDPSizePopulation

THE ENDTHE ENDPowerPoint isPowerPoint is

And I learned how to And I learned how to use it……use it……