On the Role of Financial Frictions and the Saving Rate during Trade Liberalizations

We study how …nancial frictions and the saving rate shape the long-run e¤ects of trade liberalization on income, consumption and the distribution of wealth in …nancially underdeveloped economies. In our model, regardless of whether the capital account is open or not, trade liberalization reduces the share of wealth in the hands of entrepreneurs and may well reduce steady state consumption and income. Furthermore, trade opening is more likely to reduce steady-state consumption and output, the higher is the level of …nancial development. For economies with an open capital account, a higher saving rate also increases the likelihood that a trade liberalization leads to a reduction in steady-state consumption and output. JEL Codes: E2, F1, F2, F3, F4. Keywords: Trade liberalization, capital ‡ows, …nancial frictions, saving rate, wealth distribution. Harvard and NBER, and MIT and NBER, respectively. Prepared for Journal of European Economic Association Papers and Proceedings. We thank Arnaud Costinot, Elhanan Helpman, Oleg Itskhoki and Steve Redding for helpful comments, and Fernando Duarte and Thomas Sampson for valuable research assistance. Caballero thanks the NSF for …nancial support. First draft: July 22, 2009. 1 Introduction In this paper, we study how …nancial frictions and the saving rate shape the long-run e¤ects of trade liberalization on income, consumption and the distribution of wealth in …nancially underdeveloped economies. We build on our previous work in Antràs and Caballero (2009) –AC hereafter –, where we developed a dynamic 2 2 general equilibrium model of international trade featuring heterogeneous …nancial frictions across countries and sectors. In AC, we focused on the e¤ect of trade liberalization on the steady state rental rate of capital and highlighted the result that in a world with heterogeneous …nancial development, trade and capital mobility are complements in …nancially underdeveloped economies. The goal of this paper is to describe in more detail the dynamics of the model and to derive new results concerning the role of certain …nancial and macroeconomic factors in shaping these dynamics. Our …rst key result is that when …nancial frictions are important, the standard static gains from trade liberalization can be severely diluted over time in …nancially underdeveloped economies. The reason for this is that trade integration erodes the return to entrepreneurial capital due to competition from more developed economies, which are better able to channel funds to their entrepreneurs. These induced changes in the distribution of wealth lead to an endogenous tightening of credit conditions and may well result in steady state consumption and income levels that are lower than those that would be attained without the trade liberalization. Somewhat paradoxically, we …nd that trade opening is more likely to reduce steady-state consumption and output, the higher is the level of …nancial development (provided that this level is below the average one in the world). Furthermore, for economies with an open capital account, a higher saving rate also increases the likelihood that trade liberalization leads to a reduction in steady-state consumption and output. Our work is related to the vast literature introducing …nancial frictions in international …nance and international trade models (see AC and the references therein). A particularly related paper is Chesnokova (2009) who argues that opening an economy to trade can result in welfare reducing deindustrialization when agents are subject to credit constraints. More broadly, our work is related the second-best literature in international trade (see Bhagwati and Ramaswami, 1963) The rest of the paper is organized as follows. In section 2, we develop our small open-economy model and characterize its equilibrium. In section 3, we study the e¤ects of a partial trade liberalization for the case in which the capital account is closed, while in section 4 we repeat the exercise for an economy with an open account. We o¤er some concluding remarks in section 5. 2 A Small-Open Economy with Financial Frictions Time evolves continuously. In…nitesimal agents are born at a rate per unit of time and die at the same rate; population mass is constant and equal to L. All agents are endowed with one unit of labor services which they supply inelastically to the market. Agents save all their income and consume only when they (are about to) die. Thus, if Wt denotes aggregate savings accumulated 1 up to date t, then aggregate consumption at time t is Wt, and is inversely related to the aggregate propensity to save of this economy. The economy produces two goods (1 and 2) and agents consuming at time t allocate their spending between these two consumption in a way that maximizes the following instantaneous utility function