The Growth of World Trade

______________________________________________________________________ The growth in the trade share of output is one of the most important features of the world economy since World War II. We show that an important propagation mechanism for this growth is vertical specialization. Simply put, vertical specialization occurs when imported inputs are used to produce goods that are then exported. We show that many of the standard trade models the Ricardian model, the monopolistic competition model, and the international real business cycle models cannot explain the growth in trade unless very high elasticities of demand and substitution are assumed. We then use case studies and other empirical evidence to demonstrate the quantitative significance of vertical specialization in trade. Finally, we develop a model of vertical specialization that can explain the growth in trade under reasonable elasticities, which suggests that vertical specialization has important implications for the gains from trade. ______________________________________________________________________________ Previous versions of this paper circulated under similar titles. We thank Nathan Balke, Marianne Baxter, Leonardo Bartolini, Jeff Bergstrand, David Coe, Michelle Connolly, Don Davis, Michael Devereux, Chris Erceg, Scott Freeman, Hal Fried, Linda Goldberg, Gordon Hanson, Jim Harrigan, Peter Hartley, Dale Henderson, David Hummels, Jane Ihrig, Chad Jones, Dae Il Kim, Se Jik Kim, Tom Klitgaard, Narayana Kocherlakota, Ayhan Kose, Michael Kouparitsas, Robert E. Lipsey, Keith Maskus, Monika Merz, Peter Mieszkowski, David Papell, Steve Parente, Susanna Peterson, Eswar Prasad, Dana Rapoport, B. Ravikumar, Matt Slaughter, Gordon Smith, Pam Smith, Nancy Stokey, Shang-Jin Wei, Eric Van Wincoop, Lucinda VargasAmbacher, Mark Wynne, William Zeile; seminar participants at Union College, University of Texas-Austin, the Federal Reserve Bank of Dallas, the IMF, and Southern Methodist University; and participants at the 1995 WEA meetings, the 1995 Midwest Macroeconomics Meetings, the Fall 1995 Midwest International Meetings, the 1995 Southeastern Trade Meetings, the 1996 SEDC Meetings, the International brown bag at the New York Federal Reserve Bank, the 1997 AEA Meetings, and the Spring 1997 Federal Reserve International System Meeting for useful advice. We are grateful to the Center for the Study of Institutions and Values at Rice University for its financial support. We also thank Neelay Desai, Patrik Hultberg, Jeremy Martin, Tracy Park, David Peirce, Dana Rapoport, and Brian Wahlert for excellent research assistance. The views expressed in this paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. *Stanford University, and the Federal Reserve Bank of New York and Rice University. Corresponding author: Kei-Mu Yi, International Research Function, Federal Reserve Bank of New York, 33 Liberty St., New York, NY 10045. (212) 720-6386; FAX (212) 720-6831; [email protected]