Paper presented at the Trade Conference, Research Department Hosted by the International Monetary Fund Washington, DC April 13, 2006

Transcription

1 CONFERENCE ON TRADE RESEARCH DEPARTENT THURSDAY, APRIL 3, 2006 TRADE LIBERALIZATION, ACROECONOIC ADJUSTENT, AND WELFARES: UNIFYING TRADE AND ACRO ODELS Ehsan Choudhri Carleon Universiy Hamid Faruqee Inernaional oneary Fund Sephen Tokarick Inernaional oneary Fund Paper presened a he Trade Conference, Research Deparmen Hosed by he Inernaional oneary Fund Washingon, DC April 3, 2006 The views expressed in his paper are hose of he auhor(s) only, and he presence of hem, or of links o hem, on he IF websie does no imply ha he IF, is Execuive Board, or is managemen endorses or shares he views expressed in he paper.

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3 Trade Liberalizaion, acroeconomic Adjusmen, and Welfare: Unifying Trade and acro odels By Ehsan U. Choudhri Hamid Faruqee and Sephen Tokarick April 2006 Absrac Trade liberalizaion leads o long-run gains, bu i can also involve cosly shorrun macroeconomic adjusmen. The paper explores he relaive imporance of hese effecs wihin a dynamic general equilibrium (DGE) model ha capures he key elemens of boh inernaional rade and macroeconomic models. The welfare effec of rade liberalizaion is decomposed ino a seady-sae efficiency gain and a ransiional loss arising from wage-price sickiness. Our esimaes show ha he ransiional loss is small relaive o he efficiency gain, and ends o be lower under flexible as compared o fixed exchange raes. We also show ha he loss can be reduced furher by a flexible price level argeing policy rule. JEL Classificaion Numbers: F2, F3, F4 Keywords: Trade liberalizaion; acroeconomic adjusmen, Welfare cos of ariffs Choudhri: Chancellor s Professor of Economics, Carleon Universiy, Oawa Onario Canada. Phone: , ex ehsan_choudhri@carleon.ca. Faruqee: Senior Economis, Inernaional oneary Fund, Washingon D.C.. Phone: hfaruqee@imf.org. Tokarick: Senior Economis, Inernaional oneary Fund, Washingon D.C. Phone: E- mail: sokarick@imf.org. The views expressed in his paper are hose of he auhors and should no be aribued o he Inernaional oneary Fund, is Execuive Board, or is anagemen.

4 . Inroducion There are wo disinc srands in he exensive lieraure on economic effecs of rade policy. One srand is mainly concerned wih he long-run effecs of rade policy on economic welfare and employs inernaional rade models wih flexible prices o deermine his effec. In his analysis, rade liberalizaion generally enhances welfare by improving economic efficiency. 2 The oher srand uses macroeconomic models wih nominal rigidiies o examine he shor-run consequences of rade policy on variables such as oupu, employmen and he curren accoun. The response of macroeconomic variables o rade liberalizaion in hese models depends, among oher hings, on moneary policy. For example, under fixed exchange raes, ariff cus lower he relaive price of foreign goods and (in he presence of sicky prices) normally cause a conracion of oupu and employmen as well as a defici in he curren accoun. 3 These effecs can be alered by home currency depreciaion under flexible exchange raes. 4 acroeconomic adjusmen o rade liberalizaion could poenially involve subsanial coss. There is lile work, however, which has inegraed he wo srands o compare he shor-run adjusmen coss of rade liberalizaion under differen moneary policy regimes wih he long-run efficiency benefis of his policy. Early macroeconomic models did no have srong microeconomic foundaions and hus, did no examine he welfare implicaions of macroeconomic adjusmen o rade 2 Adverse erms of rade effecs or marke failure can qualify his resul. 3 See Chacholiades (978) and Dornbusch (980) for a discussion of he macroeconomic effecs a ariff (which are opposie o hose of rade liberalizaion) under fixed exchange raes. 4 For an early analysis of he macroeconomic effec of a ariff under flexible exchange raes, see undell (96). Also see Boyer(977) and Krugman (982) for furher analysis of hese effecs. 2

5 policy. 5 The opimizing framework of he new open economy macroeconomic models, however, makes i possible o evaluae he welfare effec of macroeconomic adjusmen. These models, however, differ from inernaional rade models in imporan respecs. A key difference is ha while inernaional rade models allow wages and prices o be flexible and ofen assume compeiive condiions, macroeconomic models inroduce wage-price ineria and assume imperfec compeiion o moivae his behavior. Anoher imporan difference arises from he assumpion regarding he number of secors producing raded goods: here is one raded-goods secor in macroeconomic models, bu a leas wo raded-goods secors in inernaional rade models. These differences make i difficul o compare he welfare resuls derived from he wo ypes of models. This paper develops a simple hybrid model ha capures he key elemens of boh approaches and provides a unifying framework o examine he welfare consequences of boh he shorand long-run effecs of changes in rade policy. acroeconomic adjusmen o rade liberalizaion is capured in he model by ransiional dynamics based on wage-price ineria. The oal welfare effec of he removal of rade resricions can be decomposed ino a ransiional effec relaed o macroeconomic adjusmen and a seady-sae effec associaed wih long-run changes in resource allocaion. The ransiional effec involves a loss because sicky nominal wages and prices delay adjusmen o new seady-sae values. This loss provides a welfare measure of he cos of macroeconomic adjusmen o reducion of rade barriers. The paper esimaes welfare effecs of ariff reducion for a small emerging economy ha is financially inegraed wih he res of he world. One ineresing resul of he paper s 5 There is lieraure going back o Razin and Svensson (983), which uses an opimizing framework wihou nominal rigidiies o analyze he effec of a ariff on he curren accoun. 3

6 quaniaive analysis is ha he macroeconomic coss of a ariff reducion urn ou o be small in relaion o long-erm efficiency gains for a wide range of parameer values. The paper also explores how moneary policy affecs macroeconomic coss of liberalizing rade. In addiion o pure fixed and flexible exchange rae regimes, he paper considers an ineres rae rule ha arges he price level. The paper finds ha flexible exchange raes (which mainain a consan price level) involve a lower loss han fixed exchange raes under plausible parameerizaion. The ineres rae rule, moreover, can perform beer han pure flexible exchange raes by allowing some price adjusmen. In fac, a sufficienly weak ineres rae response o he price level can come close o duplicaing he flexible wage-price equilibrium ha eliminaes ransiional dynamics. The basic model is developed in Secion 2. Secion 3 parameerizes he model and uses i o esimae macroeconomic and welfare effecs of rade liberalizaion. Secion 4 concludes he paper. 2. Theoreical Framework 2. Basic Seup This secion develops a basic dynamic general equilibrium model o examine he shor- and long-run effecs of rade policy changes. There are wo counries, a small home counry and a large foreign counry. Two goods, and, are produced in he wo counries. The producion of each good requires labor and capial specific o each secor. Capial endowmens are fixed (as in rade models), bu labor supply is variable (as in macroeconomic models). 4

7 To inroduce nominal rigidiies in he model, i is assumed ha boh goods and labor markes are characerized by monopolisic compeiion, and changes in wages and prices are subjec o adjusmen coss. There is inerindusry as well as inraindusry rade. The home counry is a ne imporer of good and a ne exporer of good. Trade resricions ake he form of impor ariffs. Households rade a shor-erm foreign bond denominaed in foreign currency o borrow or lend inernaionally. Inernaional borrowing or lending is unresriced bu subjec o a ransacion cos ha increases in foreign deb. There are no sochasic shocks in he model and he inflaion rae equals zero in seady sae. 2.2 Consumpion and Producion The household s consumpion baske is given by η/( η ) / η ( η )/ η / η ( η )/ η C = χ C, + χ C,, () where C, and C, are consumpion indexes for goods and, η is he elasiciy of subsiuion beween he wo goods, and χ + χ =. The consumpion index for each secor is defined as / θ ( )/ / ( )/ T /( T ) T θt θt θt θt θ θ θ T T, = χth TH, + χ TF TF,, =, C C C T, (2) where, for secor T (=, ), C TH, and C TF, are consumpion bundles of home and foreign varieies, θ T represens he elasiciy of subsiuion beween he home and foreign bundles, and χ + χ =. TH TF For each good, here is a coninuum of home and foreign varieies in he uni inerval. Consumpion aggregaes of home and foreign varieies, indexed by h, f [0, ], for he wo goods are 5

8 εt /( εt ) εt /( εt ) ( εt )/ εt ( εt )/ εt TH, 0 TH, TF, 0 TF, (3) C = C ( h) dh, C = C ( f) df, T =,, where, for simpliciy, he elasiciy of subsiuion among varieies, ε T, is assumed o be he same for home and foreign bundles of each good. Opimal allocaion of consumpion expendiures beween he wo goods, beween he home and foreign bundles of each good, and among differen varieies of each bundle leads o he following demand funcions: η C = χ C ( P / P), C = χ C ( P / P), (4) η,,,, θt C = χ C ( P / P ), C = χ C ( P / P ), T =,, (5) θ TH, TH T, TH, T, T TF, TF T, TF, T, εt C ( h) = C ( P ( h)/ P ), C ( f) = C ( P ( f)/ P ), T =,, (6) ε TH, TH, TH, TH, T TF, TF, TF, TF, where PTH, ( h ) and PTF, ( f ) are he prices of varieies of home and foreign goods; P TH, and TF, P are price indexes ha minimize he uni cos of home and foreign bundles defined in (3), and P and P T, are he cos-minimizing price indexes for he aggregae baske () and he consumpion index (2). These price indexes are given by /( η ) η η P = χp. + χp,, (7) θ /( T ) T θ θ T T, = χth TH, + χ TF TF,, =, P P P T, (8) /( εt ) /( εt ) εt εt TH, 0 TH, TF, 0 TF,. (9) P = P ( h) dh, P = P ( f) df, T =, Opimal allocaion of consumpion expendiures abroad yields similar expressions for foreign demand funcions and price indexes. Leing an aserisk denoe a foreign variable, he foreign demand for home bundles and varieies can be expressed as: 6

9 εt C = χ C ( P / P ), C ( h) = C ( P ( h)/ P ), T =,. (0) * * * * θ T * * * * TH, TH T, TH, T, TH, TH, TH, TH, For each good, he producion echnology for a firm is given by he following CES producion funcion: σ /( σ ) / σ ( σ )/ σ / σ ( σ )/ σ YT, = αt LT, + ( αt) K T,, T =,, () where Y,, L, and K, represen, respecively, oupu, a bundle of labor inpus and a specific capial inpu for good ; Y,, L, and K, are he corresponding variables for good ; and σ is he elasiciy of subsiuion beween labor and capial for boh goods. The opimal choice of inpus implies he following demand funcions for labor and capial: σ L = α Y ( W / C ), K = ( α ) Y ( RE / C ), T =,, (2) σ T, T T, T, T, T T, T, T, where W is he wage index (defined below); RE, and RE, are he renal raes for capial inpus specific o goods and ; and C, and C. denoe he marginal coss for he wo goods. For each good, he marginal cos equals he minimum uni cos and can be derived from () as /( σ ) σ σ CT, = αtw + ( αt) RE T,, T =,. (3) The labor inpu bundles are aggregaes of differeniaed services supplied by a coninuum of households in he uni inerval. The aggregae index of labor services, indexed by l [0,], used in he producion of each good is defined as εl/( εl ) εl /( εl ) ( εl )/ εl ( εl )/ εl, = 0, (),, = 0, (), (4) L L l dl L L l dl 7

10 where ε L is he subsiuion elasiciy for labor services. The opimal allocaion of he aggregae labor inpu among differen services in he wo secors gives he oal demand for each household s service as ε L L () l = L ( W ()/ l W ) + L ( W ()/ l W ), (5) ε L,, where W ( l ) represens he household s wage rae and W is he following wage index (which minimizes he cos of he labor inpu bundle): 2.3 Households ε L W W () 0 l dl The uiliy of an infiniely-lived household is given by /( ε L ) =. (6) s U () l = β u[ C (), l L ()] l, (7) s s s= where Cs ( l ) is he household s aggregae consumpion. The single-period uiliy is assumed o be ρ + µ Cs () l ψ Ls () l us (.) =. (8) ρ + µ Households hold one-period domesic and foreign bonds. Domesic bonds are denominaed in home currency while foreign bonds are denominaed in foreign currency. Only foreign bonds are used for inernaional borrowing or lending and heir holding is subjec o a ransacion cos. Wage changes involve adjusmen coss. Household budge consrain is given by B ( l) + S B ( l) = ( + R ) B ( l) + S ( + R )( TC ) B ( l) W () l L ()( l AC ()) l + PF () l + RE () l + TR () l PC (), l W, (9) 8

11 where B (l) and B (l) of period ; S is he exchange rae; R and are home and foreign bonds held by households a he beginning R are he home and foreign ineres raes for a loan in period (paid a he beginning of period ); TC is he ransacion cos for foreign borrowing or lending in period ; PF ( l ) and RE ( l ) are he household s shares of oal profis and rens; TR ( l ) are governmen ransfers (discussed below); and AC, () l is he household s cos of adjusing wages. The wage adjusmen coss (as a W proporion of wage income) are assumed o be given by he following quadraic funcion: AC ω W () l W L, W, () l = 2 WL, ( l) 2. (20) Each household chooses consumpion and ses he wage rae o maximize lifeime uiliy (7) subjec o he budge consrain (9) and labor demand (5). The household opimizaion yields he following firs order condiions: βc () l P =, (2) C l P + R ρ ρ + () + S ( + R )( TC) =, (22) S + R + ( ε )( AC ( l)) W ( l) = εψl P / C W ( l) AC ( l) / W ( l) µ ρ 2 w, W, [( W ( l) W ( l) L ) /(( + R ) L )] AC ( l) / W ( l). + + W, + (23) 2.4 Firms Each firm akes he demand for is variey as given and ses prices o maximize he presen discouned value of profis. Price changes are subjec o adjusmen coss. Price adjusmen coss (as a proporion of profis) for he wo goods are of he same form as wage adjusmen coss, and are given by he following quadraic funcions: 9

12 ω PTH, ( h) P ACT, ( h) =, T =, 2 PTH, ( h) 2, (24) where he adjusmen cos parameer, ω P, is assumed o be same for boh secors. Firms in boh secors are able o price discriminae beween he home and foreign markes. For simpliciy, we assume ha prices in boh markes are se in erms of he home currency. Le P, ( h) denoe he home-currency price of a home variey of good TH T se for he foreign marke. This price is relaed o he foreign-currency price of he variey abroad as P ( h) = S P ( h)/( + τ ), T =,, (25) * * TH, TH, T * where τ T represens he foreign impor ariff rae. Le = εt P TH, P 0 TH, ( h) dh /( ε ) T, = * * εt PTH, P 0 TH, ( h) dh /( ε ) T, and use (25) o obain P ( h)/ P = P ( h)/ P. * * TH, TH, TH, TH, Using his condiion and (0), we can express profis of a home firm in each secor as PF ( h) = ( P ( h) C ) C ( P ( h)/ P ) ( AC ( h)) εt T, TH, T, TH, TH, TH, T, + ( P ( h) C ) C ( P ( h)/ P ) ( AC ( h)), T =,, εt TH, TH, TH, TH, TH, T, (26) where AC T, is he adjusmen cos for he foreign-marke price analogous o (24). The firm chooses PTH, ( h ) and P TH, ( h) o maximize D PF s, Ts, ( h ), where D s s, denoes he rae used o discoun s -period values a period. The opimal choice for P, ( h ) saisfies he following firs-order condiion: ( ACT, ( h))[( σ ) PT, ( h) σ CT, ] = PTH, ( h)( PTH, ( h) CT, ) ACT, ( h)/ PTH, ( h) (27) [ P ( h)( P ( h) C ) C )/(( + R ) C )] AC ( h)/ P ( h), T =,. TH, TH, + T, + TH, + TH, TH, + TH, = TH 0

13 The firs-order condiions for P TH, has he same form as (27) and implies ha P ( h) = P ( h). I follows ha TH, TH, P = S P + T =. (28) * * TH, TH, /( τt ),, Assuming similar price seing by foreign firms, we also have P = ( + τ ) S P, T =,, (29) TF, T TF, where τ T is he home impor ariff rae. 2.5 Equilibrium In equilibrium, all households make he same choice. Thus, aggregaing over all households, C = C ( l), L = L( l), W = W ( l). Also, since all households receive he same share of rens, profis and ransfers, RE = RE ( l), PF = PF( l), TR = TR ( l). Oupu of each secor equals demand a home and abroad, so ha Y = C + C T =. (30) * T, TH, TH,,, Foreign demand, C * TH,, is deermined by (0). The small home economy is assumed o have negligible effec on foreign prices, P * T,. Toal labor supply equals he sum of labor demand in he wo secors: L = L + L. (3),, For each secor, here is a fixed supply of capial specific o he secor. Leing a bar over he variable denoe fixed supply, we have KT, = KT,, T =,. (32) Tariff revenue is redisribued o households in he form of lump sum ransfers. Thus oal household ransfers is

14 TR = τ S P C + τ S P C. (33) * * F, F, F, F, Naional produc a home prices equals NP = P Y + P Y + TR = W L ( AC ) + RE + PF + TR. (34) H,, H,, W, Aggregaing household budge consrains, noing ha home bonds are no held abroad ( 0 B () ldl= 0 ), and using (34), we can express he naional budge consrain as SB = S( + R )( TC ) B + NP PC. (35) + Following Laxon and Peseni (2003), we assume ha ransacion coss are he following funcion of he real value of ne foreign asses TC exp( φ SB / P) = φ exp( φ / +. (36) 2 + 2SB + P The curren accoun is deermined as CA = S ( B B ). (37) + We consider a range of moneary policies. The polar cases of pure fixed and flexible exchange raes have received considerable aenion in he lieraure. These special regimes can be represened by he following assumpions S = S, (38) P = P, (39) where he pure flexible exchange rae case is idenified wih a policy of fixing he price level (or mainaining a zero rae of inflaion). We also explore a moneary policy regime ha uses he ineres rae as insrumen and arges he price level. This policy regime is described by he following ineres rae rule: R = R+ δ log( P / P), δ > 0, (40) 2

15 where R denoes he seady-sae value of he ineres rae and P is he arge price level. This rule represens a flexible price level argeing policy. A sronger ineres rae response (a larger value of δ ) would keep he price level closer o he arge. Indeed, he moneary policy rule (39) ha fixes he price level (and les he exchange rae floa) can be obained from (40) in he limi by leing δ. 3. Quaniaive Analysis 3. Calibraion We calibrae he model for a small emerging economy ha has higher ariffs iniially han he large foreign economy. Parameerizaion of he baseline model is summarized in Table. We assume ha home ariffs equal 20% while foreign ariffs * * equal 0% (i.e., τ = τ =.2, τ = τ =.). 6 We choose he following shares for differen consumpion bundles in he iniial seady sae before rade liberalizaion (a bar over a variable denoes is iniial seady-sae value). Boh goods are assumed o have equal share in aggregae consumpion, so ha PC = PC =.5PC. We also assume ha impors (which equal expors in seady sae) accoun for a quarer of aggregae expendiures, i.e., P C + P C = S P C + P C = PC. This value accords * * * * F F F F ( H H H H ).25 wih average long-run shares of impors and expors in GDP for all developing counries. 7 Given produc differeniaion, here is inraindusry rade for boh goods. We assume ha here is inerindusry rade as well and he home counry is a ne imporer (exporer) of 6 The ariff raes end o be higher for developing counries han for indusrial counries. According o recen esimaes by Anderson and arin (2006), he average (impor-weighed) ariff raes for developing and indusrial counries were 0% and 3%, respecively. We assume higher rae o allow for addiional resricions arising from non-ariff barriers. 7 The average share of impors in GDP for all developing counries over he period is 26.% and ha of expors is 25.9% (source: WEO daabase). 3

16 good (). Impors of are assumed o be 80% of oal impors while expors of are assumed o be a similar percenage of oal expors. 8 The labor share, WL / PC, is se equal o 0.6. We normalize he iniial seady sae values of consumpion and he wage rae ( CW), o equal one. We also se he iniial values of all price indexes a home ( PP,, P, PH, PF, PH, P F ) equal o one by normalizaion. 9 Given our assumed shares, hese normalizaions imply ha χ = χ = 0.5, χ = χ = 0.4, χ = χ = 0. and L = 0.6. Leing a quarer represen a uni of ime in he model, he discoun facor ( β ) is assumed o be 0.99, which implies an esimae of he annualized real rae of ineres equal o 4%. There is a wide range of esimaes for oher parameers of he uiliy funcion. For he baseline version, we choose a value of 0.5 for he ineremporal elasiciy of subsiuion (/ ρ ), and 0.25 for he elasiciy of labor supply (/ µ ). Alernaive values of hese parameers are explored in our sensiiviy analysis. Given he choice of values for ρµ,, CL,, and of ε L (as discussed below), he seady-sae version of (23) is used o deermine he value of ψ (he weigh for he labor effor index in he uiliy funcion). The subsiuion elasiciy beween he wo raded goods (η ) is se equal o 3.0. We choose a value of 6.0 for he elasiciy of subsiuion beween home and foreign bundles of each good ( θ, θ ), which is broadly consisen wih recen esimaes by Herel e al. (2004). 0 Subsiuion elasiciies for varieies of each produc caegory F H H F 8 These assumpions imply ha inraindusry rade accouns for abou 40% of oal rade for each good. 9 * * * * Foreign price indexes, P, P, P, P, are also normalized o equal one. Equaions (28) and (29) are F F * * * * * * used o deermine he values of S, P H and P H, and (0) o deermine he values of χ HC and χ HC. 0 Their esimaes of he elasiciy vary across secors and average o a value close o

17 ( ε, ε ) are assumed o equal 8.0. This value implies a mark up a lile less han 5% and is wihin he range of various esimaes for markups. As he elasiciy of subsiuion beween home and foreign varieies and he markup (reflecing he degree of imperfec compeiion) could poenially play an imporan role in deermining he effecs of rade liberalizaion, we also consider variaions of he baseline model ha allow differen values of hese parameers. Alhough he home counry is small, i sill has monopoly power (because of producing differeniaed goods) ha depends on he elasiciies of subsiuion beween home and foreign varieies in he foreign marke * * ( θ, θ ). We le hese elasiciies equal 2.0. This value leads o a reasonable value for Nash opimal ariff of less han 0%. The subsiuion elasiciy for labor services ( ε L ) is assumed iniially o also equal 8.0, which makes he markup in he labor marke he same as ha in he goods marke. Laer, we explore he sensiiviy of resuls o differen values of his elasiciy. The elasiciy of subsiuion beween labor and capial (σ ) is generally considered o be close o one, and we assume ha his value equals We inroduce labor inensiy differences beween he wo goods and assume ha good (he ne expor of he home counry) is labor inensive ( α > α ). 3 Parameers of he adjusmen cos funcions ( ω P and ω W ) deermine he degree of wage price ineria. There are no reliable esimaes for hese parameers. We use a value arins, Scarpea and Pila (996), for example, esimae he average markup for manufacuring secors in OECD counries a around 20%. Chari, Kehoe and cgraan (2002) use a markup esimae of % based on US sudies 2 For he use of a similar value, see Jomini e al. (99), for example. 3 We le α =.25α and deermine α and α o make L and L consisen wih he assumpion ha L =.6. 5

18 of 800 for each parameer in he baseline case, which is wihin he range of recen esimaes. 4 Alernaive values of he parameers are considered in our sensiiviy analysis. In he ransacion cos funcion, values of boh parameers ( φ and φ 2 ) are assumed o equal 0.0. This assumpion implies a very slow convergence o a seady sae wih zero ne foreign asses. Variaions in his assumpion make lile difference o he resuls 3.2 acroeconomic Adjusmen We firs discuss he macroeconomic effecs of rade liberalizaion under pure fixed and flexible exchange rae regimes. Trade liberalizaion akes he form of a unilaeral reducion of home ariffs from 20% o 0%. 5 DYNARE program is used o obain a deerminisic seady-sae soluion o he nonlinear model before and afer rade liberalizaion and derive he dynamic response of model variables o his policy. Figure shows he dynamic response of oupu, employmen, consumpion and he curren accoun over 20 quarers o a decrease in home ariff raes by 0. in he baseline model under he wo polar exchange rae regime. 6 The macroeconomic dynamics in his model arises from sickiness in wages and prices. To illusrae he influence of hese nominal rigidiies, he figure also displays ime pahs of he variables in a varian of he model where hese rigidiies are absen and wages and prices are fully flexible (hese ime pahs are derived by seing ω = ω = 0 in he baseline model). In his varian, here is no ransiional dynamics and he ariff cu causes all variables o P W 4 Bayoumi, Laxon and Peseni (2004), for example, use values of 400 and 700 for he Euro area and he res of he world, respecively, for he parameers of a varian of he adjusmen cos funcions used in his paper. 5 Boh τ and τ are reduced from 0.2 o 0., while 6 Oupu is defined as ( PH, Y, PH, Y, )/ P wo he firs quarer afer ariff reducion. * * τ and τ are kep equal o Quarer represens he iniial seady sae and quarer 6

19 adjus o heir new seady-sae values in he same period. The response of hese variables is very differen in he presence of nominal rigidiies for boh exchange rae regimes. In he case of sicky wages and prices and fixed exchange raes, he ariff cu lowers he price of foreign varieies relaive o home varieies and shifs demand from domesic o impored goods. This shif leads o an iniial decline in boh oupu and employmen. The oupu and employmen response in his case is opposie o ha in he model wihou any nominal rigidiy. Also, consumpion decreases less han oupu because of consumpion smoohing consideraions, and hus ariff reducion causes a emporary deerioraion in he curren accoun. In conras, home-currency depreciaion under flexible exchange raes brings abou an iniial increase in oupu and employmen as well as a curren accoun surplus by simulaing foreign demand for domesic goods and dampening he shif in home demand from domesic o impored goods. In fac, he exchange rae overshoos is new equilibrium value and he iniial expansion in oupu and employmen is greaer han ha in he absence of nominal rigidiies. Figure 2 shows he 20-quarer response of he price level, he exchange rae and he ineres rae o lower ariffs. Under fixed exchange raes, he ineres rae does no change and he price level falls gradually o accommodae relaive price changes induced by ariff cus. In he case of flexible exchange raes, on he oher hand, he price level is 7

20 no allowed o adjus and he exchange rae iniially jumps above is long-run value. 7 This response requires a sharp iniial reducion in he ineres rae Welfare Effecs We nex examine welfare effecs of rade liberalizaion under differen moneary policies. Welfare gains are measured by an equivalen-variaion index, γ, which is defined as he consan amoun (expressed as a fracion of seady-sae consumpion before rade liberalizaion) ha needs o be given o households o make hem indifferen beween he iniial seady sae and he new sae (including he ransiion period) afer rade liberalizaion. This index is given by he following relaion: s s 0 β u[( + γ) C, L] = β u( Cs, Ls ), (4) s 0 s = = 0 where { C, L } = is he sequence of consumpion and labor supply afer rade s s s 0 liberalizaion a ime 0, and u (.) is defined in (8). The index γ measures he oal welfare effec of ariff reducion and can be decomposed as γ = γ + γ, (42) TR SS where γ TR and γ SS measure he ransiional and seady-sae welfare effecs of rade liberalizaion. Leing a ilde denoe a variable s seady-sae value afer rade liberalizaion, we calculae he seady-sae index as and use (42) o deermine he ransiional index residually. u[( + γ ) C, L] = u( C, L ), (43) SS 7 The reason for he overshooing behavior of he exchange rae in response o ariff reducion is similar o ha for he well-known Dornbusch (976) resul ha under sicky prices, a permanen increase in he money supply causes he exchange rae o overshoo is equilibrium value. 8 The ineres rae, in fac falls o a level very close o zero. Noe ha a flexible exchange rae regime wih a fixed price level would no be feasible if he adjusmen requires he ineres rae o fall below zero. 8

21 Table 2 displays he welfare effecs of rade liberalizaion for he baseline model as well as wo variaions of his model. In his able, welfare indexes are muliplied by 00 o express hese in percenage erms. For he baseline model, he able shows ha lowering ariff raes by 0 percenage poins leads o a seady-sae welfare gain of abou 0.4 percen of iniial seady-sae consumpion. The ransiion process involves a loss which is larger under fixed han flexible exchange raes. However, even in he fixed exchange rae case, he loss is small and amouns o a lile over one enh of he seadysae gain. Thus our resuls sugges ha accouning for macroeconomic adjusmen makes only a small difference o he esimae of he welfare effec of rade liberalizaion. The able also explores he sensiiviy of he resuls o variaions in he assumpions abou he degree of compeiion in he goods markes. Trade models ofen assume raded goods o be more compeiive han he baseline model. Variaion moves in his direcion by raising he elasiciy of subsiuion beween home and foreign goods and lowering he markup for boh goods. In his variaion, θ = θ = 9 and ε = ε =. As would be expeced, his variaion leads o higher seady-sae gains. Ineresingly, while he ransiional loss for flexible exchange rae decreases, ha for fixed exchange rae increases. Variaion 2 explores an asymmeric case where good is less compeiive while good is more compeiive han he baseline model. For his case, we le θ = 3, θ = 9, ε = 5, and ε =. The asymmeric case does no make much difference and produces only marginal changes in boh he seady-sae and ransiional effecs. We nex explore welfare effecs of macroeconomic adjusmen under ineres rae rule (40). In his rule, parameer δ represens he moneary policy response o deviaions 9

22 from he price level arge. Alhough differen values of δ do no affec he new seadysae levels of variables, hey influence he macroeconomic adjusmen and hus can aler he ransiional loss associaed wih ariff reducion. An ineresing issue is wheher a weaker ineres rae response o he price level would improve or worsen welfare. Figure 3 shows he relaion beween he ransiional loss (00γ TR ) and δ. As he figure shows, he ransiional loss falls as δ decreases and becomes very small as δ ges close o zero. The reason ha he ransiional loss increase in δ can be explained by he help of Figure. For a very large value of δ, macroeconomic response of real variables is very close o he response under pure flexible exchange raes shown in he figure. As δ decreases, he pah of he variables moves owards he no-nominal-rigidiies pah in he figure. For very small values of δ, he ineres rae rule ges close o duplicaing he flexible wage-price equilibrium, and nearly eliminaes he ransiional loss. 9 Alhough a weak moneary policy response o he price level helps reduce ransiional losses caused by ariff cus, wo caveas need o be added. Firs, in a more general model, he opimal response would also depend on shocks oher han rade policy changes. Second, our analysis assumes ha he moneary policy can commi iself o any form of he rule. If his is no he case, a weak response o he price level may no be desirable because i could signal a lack of commimen o he price level arge. 3.4 Sensiiviy Analysis We performed exensive sensiiviy analysis o examine he robusness of our resuls o variaions in values of key parameers. We firs explored he effecs of changes 9 The equilibrium in he flexible wage-price case does no represen he socially opimal allocaion because of he presence of disorions in he model. Transiional losses, however, arise largely because of deparures from full flexibiliy of wages and prices. 20

23 in he values of ρ, µ and ε L, which could poenially influence boh shor- and long-run effecs of ariff reducion. We le ρ and µ vary from 2 o 5, and ε L from 6 o. These variaions have lile effec on he seady-sae welfare measure. The ransiional loss remains small, bu is affeced differenly by hese variaions under fixed and flexible exchange raes. For example, an increase in ρ or ε L raises he ransiional loss in he case of flexible bu lowers i in he case of fixed exchange raes. In all cases, a decrease in δ under flexible price level argeing reduces he ransiional loss, and his loss is virually eliminaed for very small values of δ. We also explored he effec of changing he values of wage-price adjusmen cos parameers ( ω, ω ) over a range from 200 o 400. An increase in he values of hese W P parameers increases wage-price sickiness and would be expeced o increases he ransiional loss associaed wih macroeconomic adjusmen. Our analysis shows ha he loss increases more rapidly under flexible han under fixed exchange raes. However, even a he upper end of he range of values for hese parameers, he loss remains small under boh regimes. 4. Conclusions Trade liberalizaion confers long-run efficiency benefis, bu i can also give rise o cosly shor-run macroeconomic adjusmen. Alhough here is an exensive lieraure on measuring long-em gains from rade liberalizaion, here is lile or no work on esimaing shor-erm coss of his policy. This paper provides esimaes of hese coss based on a framework ha incorporaes key feaures of inernaional rade and 2

24 macroeconomic models. The esimaes are derived for a small economy ha iniially has higher rade resricions in he form of ariffs han he res of he world. The paper finds ha shor-run coss of ariff reducion are higher under fixed han flexible exchange raes for plausible parameer values. In boh exchange rae regimes, however, he shor-run loss caused by ariff cus is small relaive o he long-run gain from his policy. Under fixed exchange rae, for example, he shor-run loss is abou oneenh of he long-run gain in he baseline model. The paper also shows ha macroeconomic adjusmen coss of rade liberalizaion are no only small bu also can be avoided by an appropriae moneary policy. Cosly adjusmen arises from nominal rigidiies ha impede adjusmen of relaive prices and cause real variables o emporarily depar from heir long-run equilibrium values. A flexible argeing rule faciliaes relaive price adjusmen by allowing he aggregae price level o deviae from is arge value, and hus helps reduce adjusmen coss. The paper s esimaes are based on a simple wo-secor model. The basic resuls, however, are likely o hold for exensions of he model o higher dimensions (wih more secors) and variaions ha inroduce nonraded goods and inermediae inpus. Following sandard inernaional rade models, he paper s model reas he capial sock as an exogenously deermined endowmen. Allowing capial o be deermined endogenously via invesmen would represen a significan variaion of he model. Exploring how macroeconomic adjusmen cos of rade liberalizaion would be affeced by such a variaion would be an ineresing opic for fuure research. 22

25 References Anderson, Kym and Will arin, Agriculure, Trade Reform, and he Doha Agenda, in Agriculural Trade Reform and he Doha Agenda (Washingon: World Bank, 2006). Bayoumi, Tamim, Douglas Laxon, and Paolo Peseni, Benefis and Spillovers of Greaer Compeiion in Europe: A acroeconomic Assessmen, NBER Working Paper No. 046, April Boyer, R. S., Commercial Policy under Alernaive Exchange Rae Regimes, The Canadian Journal of Economics, 0 (ay 977), Chacholiades, iliades, Inernaional oneary Theory and Policy (New York: cgrawhill, 978). Chari, V. V., Parick J. Kehoe, and Ellen R. cgraan, Can Sicky Price odels Generae Volaile and Persisen Real Exchange Raes? Review of Economic Sudies, 69 (2002), Dornbusch, Rudiger, Expecaions and Exchange Rae Dynamics, Journal of Poliical Economy, 84 (976), Dornbusch, Rudiger, Open Economy acroeconomics (New York: Basic Books, 980). Herel, Thomas, David Hummels, aros Ivanic, and Roman Keeney, How Confiden Can We Be in CGE-Based Assessmens of Free Trade Agreemens? GTAP Working Paper No. 26, arch Jomini, Parick, J.F. Zeisch, R. cdougall, A. Welsh, S. Brown, J. Hambley, J. Kelly, SALTER: A General Equilibrium odel of he World Economy, vol., odel Srucure, Daabase, and Parameers (Canberra: Produciviy Commission, 99). Krugman, Paul, The acroeconomics of Proecion Wih a Floaing Exchange Rae, Carnegie-Rocheser Series on Public Policy, 6 (982), Laxon, Douglas, and Paolo Peseni, oneary Rules for Small, Open, Emerging Economies, Journal of oneary Economics, 50 (2003), arins, J., S. Scarpea, and D. Pila, ark-up Pricing, arke Srucure and he Business Cycle, OECD Economic Sudies, 27 (996), undell, Rober, Flexible Exchange Raes and Employmen Policy, The Canadian 23

26 Journal of Economics and Poliical Science, 27 (November 96), Razin, A., and L.E.O. Svensson, Trade Taxes and he Curren Accoun, Economics Leers, 3 (983),

27 Table. Baseline odel: Parameer Values and Normalizaions Shares χ = χ = 5.0, χ = χ = 0.4, χ = χ = 0. F H H F Uiliy Parameers ρ = 2.0, µ = 4.0, ψ = 6.75 Elasiciies of Subsiuion η = 3.0, θ = θ = 6.0, ε = ε = ε = 8.0 L Technology Parameers σ =.9, α =.6, α =.76 Adjusmen and Transacion Coss ωp = ωw = 800, φ = φ2 = 0.0 Iniial Seady-Sae Values * * τ = τ =.2, τ = τ =., C =, L =.6, S =.833 W = P = P = P = PH = PF = PH = PF = 25

28 Table 2. Welfare Effecs of Trade Liberalizaion Toal Effec (%) Transiional Effec (%) Seady-Sae Fixed ER Flexible ER Fixed ER Flexible ER Effec (%) Baseline odel Variaion Variaion Noe: θ = θ = 9, ε = ε = for variaion, and θ = 4, θ = 9, ε = 6, ε = for variion 2 26

29 Figure. Dynamic Response of Real Variables o Trade Liberalizaion Oupu Employmen No Rigidiies Flexible ER Fixed ER No Rigidiies Flexible ER Fixed ER Consumpion Curren Accoun No Rigidiies Flexible ER Fixed ER No Rigidiies Flexible ER Fixed ER 27

30 Figure 2. Dynamic Response of Nominal Variables o Trade Liberalizaion Exchange Rae Flexible ER Fixed ER Price Level Flexible ER Fixed ER Ineres Rae Flexible ER Fixed ER 28

31 Figure 3. Transiional Loss under Differen values of Dela Transiional loss Dela 29