Author
From David Ricardo in the 19th century through the foundational modern work of Cole and Obstfeld (1991) and Arkolakis, Costinot, and Rodríguez-Clare (2012), economics continues to refine our understanding of the benefits of trade in an uncertain world. To date, trade economists have generally taken a “static” approach, comparing one state of the world—with free and open international trade—against other, less-free scenarios.
Minneapolis Fed Senior Research Economist Doireann Fitzgerald models two additional dimensions in which trade brings substantial benefits to national economies: over time and across possible futures (Minneapolis Fed Working Paper 809, “3-D Gains from Trade”). Seen “in 3-D,” the benefits of international trade are larger than the modest findings of most static models, especially for developing countries (see figure).
To go from one dimension to three, Fitzgerald augments a classic model of welfare gains from trade to capture an essential fact about the global economy: Countries vary greatly in their productivity—from one another and over time, as productivities grow at different rates and suffer occasional shocks. On top of the static gains previously established in the economics literature, Fitzgerald models how nations benefit from trade in two new channels:
- Risk-sharing gains—Uncertainty about future productivity creates risk, and people are naturally risk averse. Trade insures against an uncertain future with many possible states of the world, in which productivity and trade terms could be more or less advantageous.
- Intertemporal gains—Trade helps smooth consumption over time, as productivity growth rises and falls.
Across states and across time, the fluctuating terms of trade (export prices compared with import prices) can have an insulating effect against volatile productivity. In times of low productivity, better terms of trade are especially valuable, allowing the country to benefit from relatively affordable imports. Without trade, this offsetting benefit does not exist to cushion the effects of productivity slumps.
Using a dataset of more than 150 countries over 50 years, Fitzgerald establishes that productivity is highly volatile among developing countries, and their productivity is negatively correlated with the terms of trade. Richer nations, by contrast, have less volatile productivity and their productivity and terms-of-trade tend to move together. The productivity paths of developing countries are varied and idiosyncratic, whereas the risks that developed countries face are generally aggregate, affecting all of them at once. These differences in the data explain why the 3-D gains for developing countries—essentially, insurance against a rocky and uncertain future—are so much larger than for developed countries.
Fitzgerald generates results from her dynamic, multi-country model in two extreme settings: “financial autarky,” in which there is trade in goods but no trade in financial instruments, and the alternate extreme of complete and frictionless asset markets. Productivity growth and shocks are presumed to be exogenous, with national productivity growth converging in the long run to the U.S. growth rate.
Under the conservative, financial autarky scenario, richer countries (defined as members of the Organization for Economic Cooperation and Development) experience a welfare increase from trade of 22 percent in Fitzgerald’s model, versus 21 percent in the traditional static setting. For developing countries, however, trade increases welfare by 58 percent, compared with just 17 percent in a static model. Under “complete markets” conditions, the gains are larger, especially for developing countries.
Decomposing the 3-D gains from trade, Fitzgerald finds that risk-sharing gains (trade helping countries to insure against many possible future states of the world) appear to be the predominant benefit, though both the intertemporal and risk-sharing channels increase welfare.
Fitzgerald checks for robustness to critical parameters, including the degree of risk aversion. Unsurprisingly, the 3-D gains increase when people are more risk averse, and vice versa—especially in developing countries. The model is also sensitive to the degree of substitutability between foreign and domestic goods (the “Armington elasticity”). The primary findings are derived using a commonly accepted value.
The findings complement Fitzgerald’s prior work, published in the American Economic Review, in which she demonstrates how frictions in international financial asset markets had impeded the ability of developing countries to manage and share risk. Her new 3-D perspective on the benefits of trade over time and across states of the world appears to substantially raise the stakes of trade barriers—for all, but especially for poorer economies. “Developing countries are subject to a lot of idiosyncratic risk,” Fitzgerald writes. “Endogenous movements in the terms of trade provide insurance against this risk, and this insurance is valued by risk averse agents. Focusing only on the static gains from trade ignores this benefit of trade openness.”
Read the Minneapolis Fed working paper: 3-D Gains from Trade
Jeff Horwich is the senior economics writer for the Minneapolis Fed. He has been an economic journalist with public radio, commissioned examiner for the Consumer Financial Protection Bureau, and director of policy and communications for the Minneapolis Public Housing Authority. He received his master’s degree in applied economics from the University of Minnesota.
