User:Leakhena chhoeun/sandbox

Does trade openness increase macroeconomic volatility?

'''There is a view that trade can reduce GDP volatility through sectoral specialization and nationwide diversification. Is this concept generally accepted?'''

Trade openness and its effect on macroeconomic volatility is a topic that is gaining traction and has been studied by many scholars. Some scholars give the same assumption, and some have specific assumptions. However, in academic and policy discussions, which can be derived from Newbery and Stiglitz (1984), a commonly held view is that openness to global trade contributes to the higher volatility of GDP. This view originates from a broad category of international trade theories that predict that trade openness will increase specialization.

Also, a study on “Trade Openness and Volatility” implied that the overall impact of trade openness is positive and economically significant. This influence is also very different from national characteristics. The authors estimate that compared with developed countries, the same increase in openness will increase the overall volatility of developing countries five times.

Since the specialization of production, as well as lack of diversification, tends to increase the risk that a country bears the unique shocks of the country's specialized sector, it can usually be inferred that trade will increase macro-volatility. This point of view seems to exist in the policy circles, where people usually think that trade opening is a trade-off between the first and the second moments. How does a new study test these points of view?

To know if the views mentioned above are acceptable or not, a new study was used to test them. According to a research paper (Caselli et al. 2017), the authors re-examined this common sense from two aspects.

Firstly, the authors point out that existing views are strongly based on the assumption that shocks from the specific sector (i.e., shocks that impact specific sectors) are the main source of GDP volatility.

Nevertheless, the proof does not support this assumption. Country-specific shocks are at least as significant as sector-specific shocks in shaping the volatility patterns of countries-shocks common to all sectors in a given country (Koren and Tenreyro 2007). Here their main contribution is to prove that openness to global trade will decrease the volatility of GDP if a country-specific shock is a significant source of volatility. Openness, in particular, decreases the risk of a country to domestic shocks and enables it to diversify its sources of demand and supply, leading to a possible reduction in overall volatility. This can be done as long as the volatility of shock affecting trading partners is not too high, or there is not too much shock covariance across countries. In other words, they show that the sign and size of the impact of openness on volatility rely on shock variances and covariances across nations.

Secondly, the authors question the mechanical assumptions that higher sector specialization itself leads to higher volatility.

Whether with specialization, GDP volatility increases or decreases rely on the inherent volatility of the sectors in which the economy is specialized, as well as on the covariance among sectoral shocks and between sectoral and country-wide shocks.

Discussion on the results

In the sense of a quantitative model of trade and GDP determination, the authors made these points. For a variety of groups of countries, they used the model in correlation sector-level production and bilateral trade data to quantitatively determine how shifts in trading costs have influenced GDP volatility since the early 1970s and.

As a result, they found that the decrease in trade costs since the 1970s has led to a major decrease in GDP volatility in 80 percent of the countries in their study, whereas in the other third, it has led to small increases in volatility. The range of volatility shifts differs greatly across nations, with the highest decreases in volatility due to trade of over 60 percent and the largest volatility increases due to trade of around 6-8 percent. On average, volatility decreased by about 20 percent in trade.

The net effect of the two different mechanisms highlighted above is the noticeable decline in volatility due to trade: sectoral specialization and country-wide diversification. In 80 percent of the countries in their study, the country-wide diversification mechanism has again led to lower volatility, indicating that there is potential for diversification through trade. The finding that higher sectoral specialization does not always lead to greater volatility is similarly important and contrary to the conventional view. The sectoral specialization channel has led to lower volatility in approximately one-third of the countries. As with the overall net effect of trade on volatility, the relative importance of the two mechanisms underlined varies from country to country, but on average the effect of the specialization mechanism is one-third the effect of the diversification mechanism.

Conclusions

To conclude, their study contradicts the conventional view that volatility is increased by trade. It illustrates a new mechanism by which trade can decrease volatility, namely country diversification. This also shows that the standard sectoral specialization mechanism, typically considered to increase volatility, may lead to lower volatility in certain circumstances. The analysis shows that during the time they study, diversification of country-specific shocks has typically led to lower volatility and was quantitatively more significant than the specialization mechanism.

Openness to trade does not always have a clear effect on volatility, as the model and quantitative findings demonstrate. The sign and size of the effect vary between countries. This finding may partly explain why direct empirical evidence has produced mixed results on the effects of openness on volatility. Some studies argued that trade reduced volatility (Cavallo 2008, Haddad et al. 2010, Strotmann et al. 2006, Burgess and Donaldson 2015, Parinduri 2011), , , , and , while others found that trade increased volatility (Rodrik 1998, Easterly et al. 2001, Kose et al. 2003, di Giovanni and Levchenko 2009) , , , and. The model-based analysis can overcome the problem of causal attribution faced by several previous empirical studies, so counterfactual exercises can be conducted to isolate the impact of trade costs on volatility. Besides, across countries, it can deal with extremely heterogeneous trade impacts.

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