Trade Liberalization and Endogenous Growth in a Small Open Economy: A Quantitative Assessment

57 Pages Posted: 10 Feb 1999

See all articles by Thomas F. Rutherford

Thomas F. Rutherford

Centre for Energy Policy and Economics

David G. Tarr

International Trade Analysis

Date Written: May 6, 1998

Abstract

Although trade liberalization has been linked econometrically and through casual empiricism to large income increases, attempts to quantify its impact in static simulation models have shown estimated gains. This paper shows that when the endogenous dynamic effects of trade liberalization are built into simulation models, the estimated gains are indeed very large. But complementary regulatory, financial market, and macroeconomic reforms are important to realize the largest gains.

Rutherford and Tarr develop a numerical endogenous growth model approximating an infinite horizon, which allows them to investigate the relationship between trade liberalization and economic growth.

Economic theory generally implies that trade liberalization will improve economic growth, and the two phenomena are positively correlated in empirical tests, but the connection is not well-substantiated in numerical general equilibrium models.

In the authors' model, an intermediate input affects aggregate output through a Dixit-Stiglitz function. Additional varieties provide the engine of growth in this framework and the existence of this mechanism magnifies the welfare costs. In this model with lump sum revenue replacement, reducing a tariff from 20 percent to 10 percent produces a welfare increase (in terms of Hicksian equivalent variation over the infinite horizon) of 10.7 percent of the present value of consumption in their central model, where the economy is assumed to be unable to borrow on international financial markets. If macroeconomic and financial reforms are in place that would allow international borrowing, however, the same tariff cut is estimated to result in a 37 percent increase in Hicksian equivalent variation. On the other hand, if inefficient replacement taxes must be used in an economy without the capacity to borrow internationally, the gains would be reduced to 4.7 percent. Larger tariff cuts-typical of those in many developing countries over the past 30 years-produce larger estimated welfare gains at least proportionate to the size of the cut.

The authors apply the model to five developing countries and estimate the impact of the tariff changes those countries plan to undertake as part of Uruguay Round commitments. Because of the dynamic effects, estimated gains are considerably larger than those found in the literature on the impact of the Uruguay Round.

This paper - a product of Trade, Development Research Group - is part of a larger effort in the group to assess the impact of trade and investment on economic growth. The study was funded by the Bank's Research Support Budget under the research project The Dynamic Impact of Trade Liberalization in Developing Countries (RPO 681-40). David Tarr may be contacted at dtarr@worldbank.org.

JEL Classification: F43, F12, F13, C68

Suggested Citation

Rutherford, Thomas F. and Tarr, David G., Trade Liberalization and Endogenous Growth in a Small Open Economy: A Quantitative Assessment (May 6, 1998). Available at SSRN: https://ssrn.com/abstract=141995

Thomas F. Rutherford

Centre for Energy Policy and Economics ( email )

ETH-Zentrum
Zurich, CH-8092
United States
+41 (0)44/632 6359 (Phone)
+41 (0)44/632 1622 (Fax)

HOME PAGE: http://www.cepe.ethz.ch/

David G. Tarr (Contact Author)

International Trade Analysis ( email )

7901 Hispanola Avenue
Apt. 1102
North Bay Village, FL 33141
United States
5712242796 (Phone)

HOME PAGE: http://https://sites.google.com/site/davidgtarr/

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