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

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

• by ILKER KAYA

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The big question

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

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Technical Challenge

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

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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

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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.

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Main assumption

• A countrys geographic characteristics have
  important effects on its income through their
  impact on trade

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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.

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• average income in country i is a function of
• international trade and within-country trade,
• and other factors
• (1) ln Yi a ßTi ?Wi ?i.
• Yi income per person,
• Ti international trade,
• Wi within-country trade,
• ?i other influences on income.

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• international trade
• (2) Ti ? FPi di
• Piproximity to other countries,
• di other factors
• within-country trade
• (3) Wi ? ?Si ?i
• Si the countrys size,
• vi residuals (other factors)

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• The residuals in these three equations, ?i, di
  and 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(? ) in equation (1) and correlated with
  T and W

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The main equation estimated

• N population
• A area
• L dummy for landlocked countries
• B dummy for a common border between two
  countries.

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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 js 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.

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Aggregate Trade

• ln(?ij/GDPi) aXij eij,
• Tˆi ?j?i e aˆXij
• 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

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Estimates of Trades 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

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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.

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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.

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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.

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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.

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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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THE END
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