Does Trade Cause Growth? JEFFREY A. FRANKEL AND DAVID ROMER *

1. Does Trade Cause Growth?JEFFREY A. FRANKEL AND DAVID ROMER* by ILKER KAYA

2. The big question • What is the impact of international trade on standards of living?

3. Technical Challenge • How are we going to measure the effect of international trade on income (standards of living)

4. Problems • The trade share may be endogenous: countries whose incomes are high for reasons other than trade may trade more. • There is not enough available data

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

6. Main assumption • A country’s geographic characteristics have important effects on its income through their impact on trade

7. We can use geographic characteristic as IV because; • Countries’ geographic characteristics are not affected by their incomes, or by government policies and other factors that influence income. • The instrument depends only on countries’ geographic characteristics, not on their incomes or actual trading patterns.

8. average income in country i is a function of “international trade” and “within-country trade”, and other factors: (1) ln Yi =α + βTi + γWi + Єi. Yi = income per person, Ti = international trade, Wi= within-country trade, Єi = other influences on income.

9. international trade (2) Ti =Ψ + ΦPi + δi Pi=proximity to other countries, δi= other factors within-country trade (3) Wi = η + λSi + νi Si = the country’s size, vi= residuals (other factors)

10. The residuals in these three equations, Єi,δiand vi, are likely to be correlated. • The key identifying assumption of this analysis is that countries’ geographic characteristics (their P ’s and S ’s) are uncorrelated with the residuals(Є ) in equation (1) and correlated with T and W

11. The main equation estimated; N = population A = area L = dummy for landlocked countries B = dummy for a common border between two countries.

12. Results of main estimation • 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.

14. 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

18. 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 share N i=population Ai = area

19. Basic 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.

20. Basic 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.

22. Why Are the IV Estimates Greater Thanthe OLS Estimates? • The IV estimate is almost always considerably larger than the OLS estimate • There are two leading explanations • It is due to sampling variation. • OLS is in fact biased down.

23. 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.

24. Conclusions • 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.

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