ESSAYS IN INTERNATIONAL ECONOMICS

ESSAYS IN INTERNATIONAL ECONOMICS are publishedby the International Economics Section of the Depart-ment of Economics at Princeton University. The Sectionsponsors this series of publications, but the opinionsexpressed are those of the authors. The Section welcomesthe submission of manuscripts for publication in this andits other series. Please see the Notice to Contributors atthe back of this Essay.

The author of this Essay, T.N. Srinivasan, is Samuel C.Park, Jr. Professor of Economics at Yale University. Hepreviously served as Professor and, later, Research Profes-sor at the Indian Statistical Institute, New Delhi, India,and he has taught at numerous universities in the UnitedStates. He is a Fellow of the American PhilosophicalSociety, the Econometric Society, and the AmericanAcademy of Arts and Sciences, and a Foreign Associate ofthe National Academy of Sciences. His research interestsinclude international trade, development, agriculturaleconomics, and microeconomic theory. His most recentbook is Eight Lectures on India’s Economic Reforms(2000). The following Essay was delivered as the FrankD. Graham Memorial Lecture on April 13, 2000. A com-plete list of Graham Memorial Lecturers is given at theend of this volume.

GENE M. GROSSMAN, DirectorInternational Economics Section

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Library of Congress Cataloging-in-Publication Data

Srinivasan, T. N., 1933-Trade, development, and growth / T. N. Srinivasan.p. cm. — (Essays in international economics ; no. 225)Includes bibliographical references.ISBN 0-88165-132-X1. International trade—Econometric models. 2. Free trade—Econometric models.

3. Developing countries—Commercial policy—Econometric models. 4. Economic devel-opment—Econometric models. I. Title. III. Series.

HF1379.S715 2001 2001051866382′.09172′4—dc21 CIP

Copyright © 2001 by International Economics Section, Department of Economics,Princeton University.

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CONTENTS

1 INTRODUCTION 1

2 TRADE IN GROWTH MODELS 3The Neoclassical Model 3Development-Planning Models 8

3 ROBUSTNESS OF THE CONSENSUS ON OPENNESS 12Criticisms of the Consensus 12Export Promotion versus Import Substitution: Findings fromComparative Country Studies 15Cross-Country Regressions 16

APPENDIX A: THE MAHALANOBIS MODEL 22The Consumption-Goods Sector 22The Investment-Goods Sector 22Capital Accumulation 22Autarky 22Free Trade in Consumer Goods at a Relative Price of π c ofGood 2 in Terms of Good 1 and Autarky in Investment Goods 23Free Trade in Investment Goods at a Relative Price of π I ofGood 2 in Terms of Good 1 and Autarky in Consumption Goods 24

APPENDIX B: A TWO-SECTOR NEOCLASSICAL GROWTH MODEL 25

REFERENCES 29

TRADE, DEVELOPMENT, AND GROWTH

1 Introduction

Gene Grossman and Elhanan Helpman begin their classic paper on compar-ative advantage and long-run growth with the question: “What role do theexternal trading environment and commercial policy play in the determina-tion of long-run economic performance” (1990, p. 796). Their assertion that“this central question of international economics has received surprisinglylittle attention in the theoretical literature over the years” is a somewhat,though not entirely, curious statement. After all, Adam Smith’s Inquiry

into the Causes of the Wealth of Nations (1784) maintained that opennessto international trade and competition promote the accumulation of wealth,and, as Jeffrey Sachs and Andrew Warner (1995, p. 3) remark,

Smith’s followers have stressed for generations [that] trade pro-motes growth through a myriad of channels [including] increasedspecialization, efficient resources allocation according to com-parative advantage, diffusion of international knowledge throughtrade, and heightened domestic competition as a result of inter-national cooperation.

In 1919, Maynard Keynes (1971) eloquently extolled the virtues of glob-alization during its golden period before the outbreak of World War I:

What an extraordinary episode in the economic progress of manthat age was which came to an end in August 1914! . . . Theinhabitant of London could order by telephone . . . the variousproducts of the whole earth . . . and reasonably expect theirearly delivery upon his doorstep; he could . . . by the samemeans adventure his wealth in the natural resources and newenterprises of any quarter of the world, and share, without exer-tion or even trouble, in their prospective fruits and advantages.. . . He could secure forthwith, . . . transit to any country orclimate without passport or other formality, could despatch hisservant to the neighbouring office of a bank for such supply ofthe precious metals as might seem convenient, and could thenproceed abroad to foreign quarters, . . . bearing coined wealthupon his person, and would consider himself greatly aggrievedand much surprised at the least interference. But, most impor-tant of all, he regarded this state of affairs as normal, certain,and permanent, except in the direction of further improvement,

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and any deviation from it as aberrant, scandalous, and avoid-able (Sachs and Warner, 1995, p. 9).1

Keynes reversed himself during the Great Depression, but he returned to hisearlier position, at least implicitly, when he played a key role at the Bret-ton Woods conference establishing the World Bank and the InternationalMonetary Fund. The question whether trade was an “engine of growth,” asDennis Robertson (1940) claimed, or was merely a “handmaiden of growth,”as Irving Kravis ([1970] 1996) argued–or, to put it in econometric terms,whether trade was an exogenous forcing variable or an endogenous respond-ing variable in the growth process–is still being debated.

From the time of Adam Smith, therefore, until it emerged as a distinctsubfield in the 1940s, economic development was the central theme of eco-nomic inquiry. During the 1940s, the role that openness to trade has inpromoting development began to attract research and policy debate. Apessimistic assessment of the prospects for export expansion and access tointernational capital flows (based on the disastrous interwar experience withbeggar-thy-neighbor commercial policies and the collapse of internationalcapital markets) led to the widespread adoption of import substitution (IS)as a strategy for development.

Recently, the interaction among trade, trade policy, and growth hasreceived considerable attention.2 However, the distinctions between theonce-and-for-all “level” effect of trade liberalization on the level of out-put and the “growth” effect on growth of output, and between transitionaleffects and permanent or steady-state effects, have been blurred in the liter-ature. Openness to trade generates its effects through several mechanisms.Traditional theory, although not ignoring the spillover effects on one nationof the activities of its trading partners, has mostly emphasized the virtuesof unilateral exploitation of comparative advantage in production throughtrade.

By placing innovation at the center of the growth process, explicitlymodeling comparative advantage in innovation as well as production, andallowing for technological spillovers and possible imitation of innovators byothers, Grossman and Helpman have gone far beyond the earlier literature.

1There is substance to the argument that the era of the gold standard, from roughly1870 to 1913, represented a high watermark in globalization. It has taken more thaneighty years for the pre-World War I trend in globalization to resume. Although Keyneswas speaking of an Englishman during the peak of British imperial power, his descriptionis not exaggerated.

2Long and Wong (1997) have surveyed the literature on endogenous growth andinternational trade. Ben-David, Nordström, and Winters (1999) focus on the linkagesamong trade, economic growth, income inequality, and poverty. Dollar and Kraay (2001)concentrate on changes in trade policy and growth within (and among a cross-sectionof) countries.

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Their book, Innovation and Growth in the Global Economy (1991), hasbecome the locus classicus for recent research on trade and growth.

Translating the implications of simple models into testable propositions,with data that rarely correspond to their theoretical counterparts, is neithersimple nor uncontroversial. This fact is well illustrated by contributionsthat test standard trade theories (Trefler 1993; Davis et. al., 1997). Empir-ical analysis of trade policy runs into several problems, not the least of whichis the endogeneity of trade-policy choices. In addition, countries rarelychange trade policies while keeping all other policies in place. The effectsof simultaneous changes in several policies, therefore, have to be evaluatedusing a “calibrated” general-equilibrium model, rather than an econometri-cally estimated model, or by using an econometric model that “controls” forother policies. The data requirements of applied general-equilibrium mod-els are large, and assumptions underlying calibration procedures are strong.Apart from the Lucas ([1988] 1999) critique that parameters representingthe response to a policy change depend on the policy regime itself, otherproblems arise in econometric estimations of the effects of trade policy, be-cause when several policy distortions are present, the effect of changing asubset of policy distortions arising from trade is ambiguous, even in theory.

Section 2 sorts out the level, growth, and transitional effects of openingto trade in neoclassical growth models and in some of the development-planning models. It shows that it is possible, in these models, to deriveboth level and growth effects of trade policy. Section 3 comments on arecent revisionist critique of the earlier consensus on the virtues of opennessto trade from the perspective of economic development. It highlights thecontributions of Rodrik (1999) and Rodriguez and Rodrik (1999), becausethey thoroughly cover the possible bases (economic theory, econometricmethodology and techniques, and data used) on which the consensus canbe questioned. It argues that although the critique makes valid pointsagainst some of the less careful analyses, it does not seriously challenge, letalone invalidate, the consensus.

2 Trade in Growth Models

The Neoclassical Model

International trade can be easily added to the Cass-Koopmans model ofoptimal growth in a closed economy (Cass, [1965] 1991; Koopmans, [1965]1998). Assume that this economy produces a single intermediate goodusing a constant-returns-to-scale neoclassical technology with capital andlabor as inputs. In the absence of trade, each unit of this intermediategood can be costlessly transformed into a unit of consumption or a unit ofinvestment. The social planner’s problem under autarky is described below,where c denotes consumption per worker, k is the capital-labor ratio, ρ is

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the pure rate of time preference, n is the exponential rate of growth oflabor force, and δ is the instantaneous rate of depreciation of capital. Theinstantaneous felicity function u(c) is assumed to be strictly concave. Theaverage product of labor function f(k) is concave. For the moment, theInada (1963) conditions that

limk→0

f ′(k) = ∞ and limk→∞

f ′(k) = 0

will be assumed as well.Let us start with autarky. The social planner’s problem is to

maximize∫∞

0 e−ρtu[c(t)]dt , (1)

subject to k(t) = f [k(t)] − (n + δ)k(t) − c(t), with k(0) given. As is wellknown, the solution to this optimal-control problem, with k(t) as the statevariable and c(t) as the control variable, is characterized by

u′[c(t)] = λ(t) , (2)

λ(t) = −λ(t){f ′[k(t)]− (n+ δ + ρ)} , (3)

and the transversality condition

limt→∞

e−ρtλ(t)k(t) = 0 , (4)

where λ(t) is the co-state variable. Under the assumptions made, a solution[c(t), λ(t), k(t)] exists for (2) through (4), with the initial k(0) given. Thesolution converges to unique steady-state values of k∗A, c∗A given by

f ′(k∗A) = (n+ δ + ρ) , (5)

c∗A = f(k∗A)− (n+ δ)k∗A . (6)

Along the steady-state growth path, consumption, capital, and outputgrow at the same exogenous rate as the labor force. There is, thus, nogrowth in output or consumption per worker along the steady-state path.This strong implication of no long-run growth in output or consumption perworker follows from the Inada condition that the marginal product to theonly accumulable factor–namely, capital–declines to zero, because capitalincreases indefinitely relative to labor.

Let me add trade to this model. Suppose that in international mar-kets, each unit of investment can be exchanged for pI units of consumptiongoods. For simplicity, it is assumed that pI is constant over time. Thus, ascompared to a one—for—one exchange through domestic transformation,

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using international trade, the economy can exchange one unit of investmentfor pI units of consumption. This means that if pI > 1 (respectively, pI <1), the economy will transform domestically its output of intermediates intoinvestment goods (resp., consumption goods) and exchange part of it forconsumption goods (resp., investment goods) in international markets. Theremaining part is invested (resp., consumed) in the domestic economy. Letme illustrate the case of pI > 1 (the other case is analogous).

Domestic output, f [k(t)], of intermediates is first transformed costlesslyinto an equal amount of investment goods. Gross investment per worker inthe economy is k(t)+(n+δ)k(t). Thus, f(k)− k−(n+δ)k(t) of investmentgoods is exchanged for pI{f [k(t)]− (n+ δ)− k(t)} units of consumption ininternational markets. The social planner’s problem is to

maximize∫∞

0 e−ρtu[c(t)]dt (7)

subject to c(t) = pI{f [k(t)]− (n+ δ)k(t)− k(t)} , (8)

with k(0) given.It is easy to show that the optimal path under trade converges to a

steady state in which consumption, capital, and output once again all growat the same rate as the labor force, and there is no growth in per workeroutput or consumption. The steady-state values k∗T , c∗T are given by

f ′(k∗T ) = (n+ δ + ρ) , (9)

c∗T = pI{f(k∗T )− (n+ δ)k∗T } . (10)

A comparison of (6) and (10) suggests that k∗A = k∗T . Thus, from (6) and(10), it is clear that c∗T = pIc∗A > c∗A. Opening to trade, therefore, has alevel effect, that is, the level of consumption under free-trade steady state ishigher than under autarky steady state. But because in both steady states,there is no growth in per worker values of capital and consumption, thereis no growth effect.

In the special case in which marginal felicity is a constant elasticityfunction of consumption, that is, u(c) = c1−σ − 1/1 − σ, it can be shownthat the optimal path of capital-labor ratio k(t) is the same under bothautarky and free trade. However, consumption per worker under free tradeat each t is pI times its value under autarky. This being the case, there isonly a level effect, and no growth effect, even along the transition to steadystate.

Growth in per worker consumption along the steady state can be gen-erated in this model in several ways. One way is to abandon one of theInada conditions and assume that the technology exhibits a positive floor

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to the marginal product of capital, because capital increases indefinitelywith respect to labor.3

For example, consider the function f(k) = g(k) + βk with 0 < α <1, β > 0. Let limk→∞ g′(k) = 0. Then, limk→∞ f ′(k) = β > 0. With thisproduction function, and the above utility function, it can be shown thatthe steady-state growth rate of per capita consumption under both autarkyand free trade with pI > 1 is 0 if β ≤ (n+ δ + ρ), so that trade has a leveleffect but no growth effect. If β > (n+δ+ρ), the growth rate of per capitaconsumption under trade is β−(n+δ+ρ) > 0. Thus, trade has both a leveland growth effect. If, however, pI < 1 and β > pI(n+δ+ρ), the growth rate

of per capita consumption under trade is 1σ

[βpI

− (n+ δ + ρ)]> 0. Thus,

there is in this case, also, both a level effect and a growth effect of freetrade. If β > (n+ δ+ ρ)pI , the steady-state rate of growth of consumptionperworker is positive in both autarky and free trade,whatever the value of pI .

Two points from this analysis are noteworthy. First, once there is a suffi-ciently high floor on the marginal product of the accumulable factor–thatis, capital–growth in the steady-state per worker consumption becomesfeasible under autarky. Second, given a positive floor on the marginal prod-uct of capital, if the terms of trade are sufficiently favorable, the economycan achieve a positive steady-state growth in consumption per worker, evenif such growth is not possible under autarky. If pI < 1, comparative advan-tage of the economy is in the consumption good, so that more units of in-vestment good can be obtained through trade for each unit of consumptionrelinquished. Engaging in free trade enables the economy to accumulatemore capital relative to autarky.

Another approach to generating sustained growth in output per workerin the long run is to introduce a third factor of production the accumulationof which does not yield inexorably diminishing returns.4 Paul Romer ([1986]

3Given constant returns to scale, this assumption implies that labor is not essentialto production, that is, output can be produced with capital as input and no labor. Thisis seen as follows:

Let∂F

∂K> β for all (K,L).

Then,

F (K, 0) � K∂F

∂K> βK > 0.

4Stokey (1996) also uses a three-factor model in which physical capital and unskilledlabor are good substitutes and skilled labor is complementary to the aggregate. However,her focus is not growth, but a comparison of factor returns in a closed economy withtwo types of economic integration, one in which a small economy experiences capitalinflows from abroad and one in which the economy freely integrates with a larger andmore developed neighbor and factor price equalization holds.

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1997) and Robert Lucas ([1988] 1999), whose seminal contributions initi-ated the literature on endogenous growth, do just that. In Lucas’s model,the third factor is human capital, which, because its accumulation doesnot yield diminishing returns, enables Lucas to obtain sustained growthin per worker output in the steady state, even in the absence of positiveexternalities associated with human capital. In Romer’s model (1986, p.1003), the third factor is knowledge capital. Although the production ofnew knowledge is through a technology that exhibits diminishing returns,

the creation of new knowledge by one firm is assumed to have apositive external effect on the production possibilities of otherfirms . . . [so that] production of consumption goods as afunction of stock of knowledge exhibits increasing returns; moreprecisely, knowledge may have an increasing marginal product.5

Yet another approach, which dates back to Robert Solow’s ([1956] 1991)celebrated paper, is to assume labor-augmenting technical progress. In sucha model, effective labor grows faster than raw labor and, so, even thoughoutput per unit of effective labor does not grow in the steady state, outputper unit of raw labor grows at the same rate of labor-augmenting technicalprogress. In Solow’s model, the rate of labor-augmenting technical progresswas exogenous. By emphasizing innovation as an endogenous engine ofgrowth, modeling the incentives to innovate in an appropriate way, recogniz-ing the possible spillovers of innovation from innovating firms or countriesto other firms and countries through imitation or otherwise, and analyzingthe impact of such spillovers and imitation on the overall rate of growth,recent contributions to growth theory, primarily by Grossman, Helpman,Aghion, and Howitt have vastly advanced our knowledge of the growthprocess. Certainly, these innovation-based models, with their imperfectlycompetitive market structure, are relevant to development, particularly ofthose developing countries that are able to imitate and reverse-engineerproducts innovated by rich countries. The models are not, however, rele-vant to most countries. Less than a tenth of global expenditure on researchand development (R&D) is made by developing countries, and this amountis concentrated in fifteen of those countries (Coe, Helpman, and Hoffmais-ter, 1997, p. 145, n. 3). In most developing countries, therefore, trade isless apt to promote domestic innovation than to enable those countries to

5Eicher (1999) considers a model with two goods-producing sectors (producing a “low-tech” and a “high-tech” consumption good) and an education sector that teaches skillsto unskilled labor as teachers. The education sector produces as a byproduct a nonrivaltechnology the use of which in production requires skilled workers. This model hasfeatures of the Lucas and Romer models. In a two-country world, trade in goods aloneis sufficient to reduce differences in rates of growth and technological change between aleader and laggard economy.

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access the fruits of R&D expenditures in rich countries by importing equip-ment embodying technology that the rich countries have innovated (Coe,Helpman, and Hoffmaister, 1997).

Development-Planning Models

In a production technology with a positive floor to the marginal product ofcapital, asymptotically, labor is inessential to production. Thus, a modelwith such a technology reduces, in the limit, to the old Harrod-Domarmodel, in which capital is the only factor of production. This model wasfashionable in the 1950s among development planners. In fact, India’s firstfive-year plan for the 1951—56 period explicitly used it. Contemporaryendogenous-growth theorists insufficiently familiar with the earlier litera-ture have christened it the “AK model”!

A two-sector version of the Harrod-Domar model is associated with thenames of Grigorii Fel’dman (1928) of the Soviet Union, who formulated itin the late 1920s, and Prasanta Mahalanobis (1955) of India, who inde-pendently arrived at it and used it as an analytical foundation for India’ssecond five-year plan. It is a model of a closed economy in which there aretwo sectors, one of which produces a consumption good, the other, a capitalgood. Capital is the only factor of production, and the output of each sec-tor is the product of the stock of capital in existence in that sector and itsoutput-capital ratio.6 Although the flow of output of the investment-goodssector can be allocated in any fashion to augment the stock of capital ineither sector, once installed in a sector, capital cannot be shifted to theother sector.

Fel’dman and Mahalanobis show that the long-run growth rate of out-put in both sectors is a monotone-increasing function of the proportion ofthe investment-goods output that is invested in the capital-goods sector.Mahalanobis used this result to argue that India should invest in heavyindustries to achieve rapid long-run growth of both consumption and in-vestment.

Just as in the one-sector Harrod-Domar model, opening the economyto trade in the two-sector Fel’dman-Mahalanobis model can produceboth level and growth effects. An expanded version of the model, however,illustrates that the growth implications of opening the consumption-goodssector to trade are different from those of opening the capital-goods sectorto trade.

6Fisher (1995) analyzes a two-sector model in which consumption goods are pro-duced with a constant-returns-to-scale technology using labor and capital, and invest-ment goods are produced with a fixed input of capital per unit of output using capitalas the only factor of production (thus avoiding diminishing returns). In a two-countryworld, transferring wealth from low-saving to high-saving countries promotes growth inthis model.

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Let us assume two consumer goods as well as two investment goods(instead of one each), with the marginal product of capital being constantin the production of each good. Let the utility function, and the aggre-gation function that transforms the output of the two investment goodsinto aggregate investment, be Cobb-Douglas, and let capital stock be freelyshiftable within each sector, but not between sectors. Let us assume, forsimplicity only, that the share of investment devoted to the accumulationof capital stock in the capital-goods sector is exogenously fixed, rather thanendogenously determined through intertemporal welfare maximization.

Appendix A shows that in an economy under autarky, all four goodswill be produced in positive amounts. Suppose, now, that this economyis opened to free trade in consumer goods and that the relative price ofthe two consumer goods is fixed in world markets. The economy will thenspecialize in producing one of the two consumer goods (the one in whichit has a comparative advantage) and will trade some of it for the other.As long as the share of investment devoted to the capital-goods sector isunchanged, however, and that sector is closed to foreign trade, the long-rungrowth rate of the economy will be unchanged, even though the welfare ofthe economy will rise relative to autarky. If, however, the capital-goodssector is opened to free trade (again at fixed world relative prices), butthe consumer-goods sector is kept closed, there will be a positive long-rungrowth effect and a welfare effect relative to autarky. The implication isthat keeping the growth-inducing sector (which is the capital-goods sectorin this model) closed to international competition is costlier than closingthe consumer-goods sector, because the capital stock in both sectors willbe lower at each point of time in the former case than in the latter. Butkeeping neither closed would be even better, because for this small economy,there is no market power to be exploited through a tariff policy nor anydynamic externalities from learning effects to be internalized in the model.

Theoretical analyses of the effects of opening an economy to trade withthe rest of the world can be classified into two broad categories. The firstis concerned with gains from trade and extends to an open economy theresults of neoclassical welfare economics of general competitive equilibriumof a closed economy. In a world of open economies, therefore, production,consumption, and market exchange occur among agents located in differentnations. The simplest model of this world is a static one without uncer-tainty, in which production and consumption occur within each nation, onlygoods (and not factor services) are traded across national boundaries, andany transfers of income or redistribution of initial endowments are restrictedto agents located within each nation. It has been shown (Grandmont andMcFadden, 1972) that the two fundamental theorems of neoclassical welfareeconomics for closed economies also hold for open economies under the same

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assumptions about technology and taste (Koopmans, 1957). Thus, first, acompetitive equilibrium of the international economy is Pareto optimal–that is, relative to the equilibrium, no consumer in any nation can be madebetter off without some other consumer in some other nation being madeworse off. Second, a feasible allocation of production, consumption, andtrade among agents in all nations that is Pareto optimal can be sustained asan international competitive equilibrium, provided there is a lump-sum re-distribution of incomes (or initial endowment) among agents located within

each nation. An important corollary is that an international competitiveequilibrium can always be found that Pareto dominates the autarky com-petitive equilibrium of each nation.

The simple static model has been extended (as it was for a closed econ-omy) to allow for trades across time and uncertain states of nature underthe assumption of the existence of complete markets for contingent com-modities. Two equivalent versions of the extension exist. In one, marketsfor sales and purchases of contingent claims open and clear at time zero,and agents make and accept deliveries during other periods to which theyhave committed themselves in their trades at time zero. In the second ver-sion, asset markets and spot markets operate in each period. Assets arepromises to deliver specified amounts of different commodities contingenton the date of deliveries and the state of nature that is realized. Equilib-rium in spot markets and asset markets equate the supply and demand foreach commodity and asset. The basic message of the general static modeland its extensions is simply that there are gains to be realized from in-ternational trade. But this model is far too general to infer much aboutaggregate growth or patterns of trade (that is, which nations would exportand import each commodity). Propositions about comparative advantageand the resulting patterns of trade have been derived from particular andsimpler versions of the general model.

The second category of models consists of an extension to an open econ-omy of closed-economy aggregate-growth models of both the neoclassicalkind, in which the rate of growth in the steady state is exogenous, andthose models in which the rate is endogenous. The focus of analysis is theimpact that opening to free trade with the rest of the world will have on thegrowth path of an autarkic economy, it being assumed that the economy isa price taker in world markets.

It is almost banal, but nonetheless true, that the sources of growth(ignoring, for the moment, the distinction between short-run and long-run, or steady-state, growth) are essentially three: factor accumulation,improvements in efficiency of resource use (that is, growth in total-factorproductivity [TFP]), and innovation. Broadly speaking, being open to tradeand investment can enhance the growth prospects of a small open economy

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by influencing each of these three sources of growth through the followingmechanisms.

First, it can exert influence through the static gains from trade, whichamount to an increase in TFP. By reallocating resources in response toworld market prices (different from domestic autarky prices), the economyproduces more value at world prices from the same total resources thanunder the autarky allocation. Another mechanism through which opennessincreases TFP is by making available a large number of differentiated inputsin circumstances in which scale economies place limits on the number ofinputs an economy can produce in autarky. These gains from trade expandthe options available for consumption and factor accumulation. Thus theeconomy can, for instance, invest all the gains in factor accumulation andthereby increase growth, at least in the short run.

Second, it can exert influence through factor inflows and outflows. Anopen economy can, in contrast to an autarkic economy, more cheaply obtainfactors (or their services) with which it is less well endowed, and earnmore for factors with which it is better endowed, relative to the rest of theworld. Once again, these gains can be used partly to accumulate factorsand enhance growth.

Last, it can exert influence through technological progress. Opennessenables an economy to enjoy the fruits of innovation anywhere in the world.The access to foreign technology can be through (but not limited to) theimports of goods embodying such technology. Except for innovation, allthe mechanisms affect growth through factor accumulation.

Of course, dysfunctional and inappropriate policies can eliminate thegains from openness. And, as second-best theory teaches us, partly re-dressing some of the dysfunctional policies need not result in gains fromopenness. But second-best considerations constitute only a case for elimi-nating dysfunctional policies, not a theoretical case against openness.

Turning again to the effects of factor accumulation, we note that thestandard results of aggregate growth theory for a closed economy havetheir analogs for small open economies. Given constant-returns-to-scaleproduction functions with capital and labor as the only inputs, the steady-state growth rate of output per worker equals the exogenous growth rateof the labor force in both closed and open economies. Thus, output perworker is constant in the steady state so long as the marginal product ofcapital diminishes to zero as the capital-to-labor ratio increases indefinitely.In both economies, positive growth in steady-state output per worker ispossible only if the marginal product of capital has a sufficiently high lowerbound.

In the absence of such a lower bound, any increase in the investment rateyields only a transitional increase in the growth rate of output per worker,

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although it raises its steady-state level. Opening to trade raises output aswell as savings and investment along the growth path relative to autarky.In the absence of a sufficiently high positive lower bound on the marginalproduct of capital, therefore, it has only a transitional effect on the growthrate of output per worker. As noted above, in a technology with a positivelower bound to the marginal product of capital, labor is not essential toproduction, and so its exogenous growth rate cannot bound the steady-state growth ratio of aggregate output. Thus, the growth rate of capitalbecomes the limiting factor for asymptotic growth, or put another way,capital is the growth-inducing factor. This, in turn, means that an increasein the investment rate in a closed economy (and the induced increase ininvestment through the output-raising effect of trade opening) raises thesteady-state growth of aggregate output.

Endogenous-growth models focus on growth-inducing factors other thanphysical capital. Human-capital accumulation, as in Lucas ([1988] 1999),can generate steady-state growth in output per head as long as its accumula-tion does not run into marginal returns diminishing to zero. Another factor,knowledge capital, also escapes the curse of diminishing returns (Romer,[1986] 1997). To the extent that human capital is accumulated throughlearning, and learning effects peter out in the production of any singleproduct, steady-state growth can be obtained only through the process ofintroducing new products (as in Stokey, 1996). Again, being open to tradeincreases the probability that new products will be introduced. Last, butnot least, being open not only enables an economy to access the knowledgecapital accumulated elsewhere, it can also improve the efficiency of its ownknowledge-accumulation process.

It is clear, in theory, that there are several mechanisms through whichopenness enhances growth. Whether or not these mechanisms operate inpractice is an issue for empirical analysis. As we shall see in the nextsection, identifying the growth effects of trade empirically is a challengingtask.

3 Robustness of the Consensus on Openness

Criticisms of the Consensus

Francisco Rodriguez and Dani Rodrik (1999), have reviewed recent empiri-cal studies that strongly support the consensus on the virtues of openness.7

They claim to have identified several weaknesses endemic to the literature

7Recent contributions on growth, trade, and technology spillovers based on cross-country regressions are too numerous to be listed, let alone surveyed. These includeBen-David (1995, 1996), Coe and Helpman (1995), Sachs and Warner (1995), Barro andSala-i-Martin (1997), Coe, Helpman, and Hoffmaister (1997), Ben-David and Loewy(1998), and Bayoumi, Coe, and Helpman (1999).

12

that make them skeptical “that there is a strong negative relationship indata between trade barriers and economic growth, at least for levels of traderestrictions observed in practice,” and they view “the search for such a re-lationship as futile” (p. 38). Their summary assessment of “the moderntheory of trade policy as it applies [to] a small economy that takes worldprices of tradable goods as given” leads them to conclude that

there should be no theoretical presumption in favor of finding[an] unambiguous negative relationship between trade barriersand growth rates in the types of cross-national data typicallyanalyzed. . . . Moreover an increase in the growth rate ofoutput is neither a necessary nor a sufficient condition for im-provement in welfare (p. 5).

Rodrik (1999), in a policy-oriented analysis, goes further than Rodriguezand Rodrik (1999). He states:

First, openness by itself is not a reliable mechanism to generatesustained economic growth. Second, openness will likely ex-ert pressures that widen income and wealth disparities withincountries. Third, openness will leave countries vulnerable toexternal shocks that can trigger domestic conflicts and politicalupheavals (pp. 13-14).

The import substitution (IS) policies that followed in much ofthe developing world until the 1980’s were quite successful insome regards and their costs have been vastly exaggerated(p. 64).

ISI worked rather well for about two decades. It brought un-precedented economic growth to scores of countries in LatinAmerica, the Middle East, and North Africa, and even to somein Sub-Saharan Africa (p. 99).

The evidence in favor of the small government/free trade ortho-doxy is less than overwhelming. Investment and macroeconomicpolicies remain key. There is no magic formula for surmountingthe challenges of economic growth. If there is, openness is notit (p. 141).

The economies that have done well in the post-war periodhave all succeeded through their own particular brand of het-erodox policies. Macroeconomic stability and high investmentrates have been common, but beyond that many details differ(p. 47).

13

This is quite a list of criticisms. The implication is that the postwarcase for openness in trade policy, especially when linked to improved perfor-mance in economic growth and, in turn, to improvement in welfare, shouldbe rejected. An evaluation of these arguments leads to the conclusion thatthey amount to little that policymakers need to worry about when recom-mending a policy of trade openness.

First, the criticism is that, in theory, there is no presumption that open-ness in trade (that is, the export-promoting [EP] strategy) will accelerategrowth more than the import-substitution (IS) strategy will. It is true thatin the conventional economic models, freer trade raises income once andfor all but that it cannot raise its growth rate in a sustained fashion. Asdemonstrated above, this is so in the standard version of a Cass-Koopmansmodel. In the version of that model without the Inada condition, however,or in the Harrod-Domar model and Fel’dman-Mahalanobis putty-clay mod-els, it is not the case. In fact, Rodriguez and Rodrik (1999, p. 5, n. 7)recognize this. Even if one were to reject as unrealistic models that havepositive lower bounds on the marginal product of capital, one could stillargue that the relevant time horizon for growth for developing countries isnot the very long run, but the short to medium run. Even though opennessto trade does not alter the long-run growth rate in standard neoclassicalmodels, it does raise the growth rate in the transition to the long-run steadystate, that is, within the time horizon of relevance to developing countries.

At another level, countless arguments and models can be, and have been,made that show that free trade will reduce current income and even growthcompared to autarky, if market failures are present. Bhagwati (1958) showsthat growth under free trade may even lower welfare. This can happen ifthere are distortions in place as growth occurs. However, this finding arguesagainst the IS strategy. One reason why the IS strategy has not workedwell is that it used quantitative restrictions and other trade barriers toattract foreign investment. Given the trade distortion, this investmentreduced the social returns and may even have created social losses.8

Sure enough, therefore, one can ingeniously formulate anti-free-tradetheories. But in formulating policy, one must next ask: Do we view suchtheories as representing a “central tendency” in the real world or merely as“pathologies”? These policy judgments cannot be avoided, because to doso is to become a prisoner of the nihilistic view that because anything canbe logically shown, nothing can be empirically believed and acted upon. Inmaking such judgments, the most useful evidence can come only from care-

8See Brecher and Díaz-Alejandro (1977) for a formal demonstration and Bhagwati(1974) for application of the argument to an evaluation of the IS strategy’s demerits.

14

ful studies of policy regimes of individual countries, preferably in a com-parative framework.

Export Promotion versus Import Substitution: Findings from Comparative

Country Studies

Among the comparative country studies, those by the Organisation forEconomic Co-operation and Development ([OECD] Little, Scitovsky, andScott, 1970), the National Bureau of Economic Research ([NBER] Bhag-wati, 1974; Krueger, [1978] 1997), and the World Bank (Balassa, 1971) werethe most influential. They played a critical role in shifting policies in severaldeveloping countries away from the IS strategy and in getting the WorldBank to enforce trade reforms more fully. These policy studies stronglysuggest that the theoretical possibilities that could inversely relate growthto openness were not forgotten. Rather, they were discounted in light ofthe systematic in-depth and nuanced analyses of country experiences inthese projects. The policy judgment that many drew from these studieswas that the EP strategy was conducive to significantly higher growth on asustained basis than was the IS strategy, which produced, after an early pe-riod of often-government-stimulated investments, an unsustainable growthpath.

Little, Scitovsky, and Scott (1970) directed seven case studies for theOECD of industrialization in Argentina, Brazil, India, Mexico, Pakistan,the Philippines, and Taiwan. They find that, first, in all of these countries,the industrialization strategy had initially protected the internal marketthrough high customs duties and import quotas; second, the countries hadthen reached a stage at which policies to promote IS were proving harmfuland had led to the creation of high-cost enterprises; and third, these enter-prises had come to depend for their profits on government decisions and,so, had developed a habit of devoting their efforts to obtaining privileges byputting pressure on the government, instead of cutting costs. The authorsconclude that the emphasis should be shifted from IS to EP to replace high-cost internal production by reorganized agricultural and industrial sectorscapable of gradually becoming competitive and assuming their place in theworld market.

Bhagwati (1974), one of the codirectors of the NBER studies, attributesthe superiority of EP to IS strategy to several possible factors, includingthe “neutrality” of the incentives that define the pattern of industrial andexport composition under EP as opposed to the “chaotic” non-neutrality ofthe incentives that arise under IS and the improved economic performancethat follows the removal of the bias against exports under IS. The improvedeconomic performance was, in his view, caused not so much by the moreefficient export-competition pattern under EP, as by the vastly improvedexport performance under EP.

15

Under EP, the effective exchange rate for exports is not raised a greatdeal relative to the rate for imports–in other words, the distortionaryeffects of export incentives are modest. This is true for a number of reasons.EP often occurs within a context in which the IS strategy is still in place,and the objective is to offset or reduce the bias against exports caused byIS, rather than to create an excessive bias in favor of exports. In addition,unlike import tariffs (and import quotas, if these are auctioned), exportsubsidies have to be financed from other revenues. The ability to subsidizeexports is therefore limited by its budgetary cost. Moreover, to the extentthat EP succeeds in raising export earnings, it will ease the balance-of-payments position, which, in turn, will ease the excesses of IS strategy.

Finally, the EP strategy can influence the access to, and quality of,foreign-capital flows. The improved ability to service debt, because of im-proved export performance, will not only enhance the capacity to borrowabroad, it will also attract more and better foreign direct investment, be-cause an emphasis on exports will induce foreign investors to take advantageof low production costs to produce for export markets. This means thatunder the EP strategy, investment will flow to export industries, that is, tothose industries in which the economy has a comparative advantage, ratherthan to sectors protected by import tariffs, as under the IS strategy. Suchinvestments will be welfare-improving, rather than welfare-worsening, astariff-jumping investments attracted by the IS strategy are. Bhagwati findsempirical evidence supporting one or more of these mechanisms throughwhich the superiority of the EP strategy manifests itself.

Anne Krueger ([1978] 1997), in her synthesis of the NBER studies, alsoaffirms the superiority of the EP to the IS strategy. She finds two classesof influence that appear to make the EP strategy more conducive to rapidgrowth. One class consists of economic factors. These include the exploita-tion of scale economies and efficiency induced by the greater competitioncreated by serving a large global market under the EP strategy, rather thana limited domestic market under an IS strategy. The other class consists ofrestraints imposed by the EP strategy on the government’s ability to pur-sue and implement dysfunctional economic policies. These restraints arisefrom the fact that unlike the IS strategy, which can be implemented throughquantitative restrictions and tariffs that generate revenues, the EP strategyalmost certainly cannot be implemented through quantitative restrictions.It necessarily has to rely on influencing prices received by exporters–forexample, through subsidies–and, as noted above, the budgetary cost ofsubsidies limits their excessive use.

Cross-Country Regressions

Policy-evaluation studies in effect ask a counterfactual question: What wouldhave happened if a country had a set of policies different from the one it

16

actually followed? There are several empirical methods for answering thisquestion. If some countries have changed policies, one can use data fromthese countries from before and after their policy change (the so-called“before-and-after” approach). Alternatively, one can compare the outcomesin countries that have changed policies with those of a similar group of coun-tries that have not ( the so-called “control-group” approach). The NBER,OECD, and World Bank studies represent a combination of these two meth-ods. Their comparisons of the performance of individual countries as theirpolicy regimes change over time are the equivalents of the before-and-aftercomparisons. Their intercountry comparisons are similar to, although notquite the same as, comparisons in the control-group approach.

Other methods include simulations of the effects of a policy change in acountry, typically from an applied general-equilibrium model, and versionsof a difference-in-difference approach, in which one compares the differencein outcomes between countries that have changed policies with the controlgroup before the former changed policies with the difference after theychanged policies. There is also the recently popular cross-country-regressionapproach. Each of these methods has its own strengths and weaknesses.

Among the many reasons to be skeptical of the findings of most of theseregressions are their weak theoretical foundations, the poor quality of theirdata bases, and their inappropriate econometric methodologies.9 A typi-cal regression of this genre will have some outcome variable (for example,average growth rate over some period) on the left-hand side (LHS) anda number of variables on the right-hand side (RHS) that are viewed asdeterminants of, or factors influencing, the LHS variable. The directionof influence is viewed as going from the RHS variables to the LHS vari-able. In an openness context, the RHS variables will include a proxy foropenness, other possible systematic determinants of growth such as ratesof investment (including proxies for human-capital investments or stocks),dummy variables to capture factors specific to a country, region, or period(even including dummies for civil wars, coups and revolutions, and religionof the majority of the population), and a host of factors that are viewed asidiosyncratic influences on growth. In a cross-sectional context, the samerelation between RHS and LHS variables (other than country dummies) isassumed to apply for all countries. In a single-country time-series context,the same relation between RHS and LHS variables (other than time dum-mies) is assumed for all time periods. There are a number of problems withthe use of such regressions.

9Rodriguez and Rodrik (1999) are rightly critical of regressions showing a positiverelation between trade openness and growth. However, they do not reject the regressionmethodology itself, but only the particular applications of the methodology by others.They run similar regressions but reach different conclusions by using different data setsand variables.

17

First, the postulated relationship is often not derived from any theoret-ical model. Even when it is, the link in the econometric specification of therelation between theory and the estimated regression is far more tenuousthan is often realized, because economic theory rarely specifies the func-tional forms for the relationships, let alone the probability distribution ofthe stochastic error terms.10 To assert, therefore, that a hypothesis (forexample, a positive relation between growth and openness) is conclusivelyestablished or refuted by the regression is to claim too much.

Second, there is no reason to presume, even in theory, that the directionof the relationship runs only from the RHS variables to the LHS variable. Ifit goes both ways, then the LHS variable and a subset, if not all, of the RHSvariables are jointly determined. The postulated regression is then only oneof a set of relationships characterizing the interrelations among jointly de-termined variables. That being the case, unless treated econometrically, soas appropriately to address this simultaneity problem, parameter estimatesfrom a single equation using ordinary least squares (OLS) will not be con-sistent and cannot be interpreted meaningfully. To be fair, a few carefulempirical researchers do attempt to address the endogeneity of some of theRHS variables arising from simultaneity by using other than OLS estima-tion techniques, such as two-stage least squares or instrumental variables.Nonetheless, this remains an infrequent practice. In addition, if sufficientnumbers of observations are available, it is also possible to test whether,rather than assume that, the relation between RHS and LHS variables isthe same across countries or over time. One can even adopt a nonpara-metric specification of the relationship. Limitations of data, however, oftenpreclude these options.

Third, many of the RHS variables not only are often poor empiricalproxies for their theoretical counterparts but are also subject to errors andbiases of measurement. For example, defining a variable that captures theinfluence of a nontariff barrier in a theoretical relationship and then findinga reasonable empirical proxy for it are not easy tasks. Measurement error inan RHS variable biases not only the estimate of the parameter embodyingits effect but also the estimates of parameters embodying the effects ofother RHS variables–the direction of bias not being predictable except invery simple situations. In addition, dummy variables are best described as“dumb” variables; they are introduced to capture the influence of factors(civil war, revolutions, coups) of which the analyst often has no knowledge.

10Except in empirical studies such as those based on real-business-cycle models, inwhich it is integral to the model, the stochastic error term is added on to a purely de-terministic theoretical equation, a practice that can be justified only if the RHS variableis the sum of its “true” value and a stochastic measurement error.

18

The estimated value of the parameter associated with a dummy variable ismerely a quantitative measure of this ignorance.

Fourth, in the context of relationships that have a temporal as well ascross-sectional dimension, there is the well-known problem that the esti-mated impact from a cross-section of an RHS variable on the LHS variableneed not be the same as that from time-series data.

Fifth, it is highly unlikely that cross-country regressions, relying in-evitably on simple proxies of critical explanatory variables such as tradepolicy, can reliably address the empirical reality of the trade-and-growthlink in country experiences. In fact, even the LHS variable, the growthrate of GDP, needs to be handled with empirical and conceptual care. Notonly do we know that the estimated growth rates and country rankingsare sensitive to whether one uses conventional estimates or the Kravis-Heston-Summers estimates (Kravis, Heston, and Summers 1982; Summersand Heston, 1991). We also know that, from a welfare-theoretic viewpoint,there is a good case for reevaluating the growth rate of each country at itsinternational prices, as suggested by Little, Scitovsky, and Scott (1970) andanalyzed by Bhagwati and Hansen (1973). Studies by Balassa (1971) andothers suggest that when this is done, the high early growth rates under ISstrategy in countries such as Brazil will be revised drastically downward.The crude regressions on growth and trade, however, almost never face upto these difficulties, which can be, and often have been, faced squarely innuanced and intensive country studies.

The stream of studies based on regressions is continuing, each new pa-per attempting to address the perceived econometric and data weaknessesof earlier studies. One such study, by David Dollar and Aart Kraay (2001),focuses on post-1980 “globalizers,” defined as countries in the top one-thirdof developing countries in terms of the increase in the share of trade in theirGDP from 1977 to 1997. This group cuts import tariffs by three times asmuch as the bottom two-thirds of “nonglobalizers.” The authors find thatalthough growth rates in rich countries and nonglobalizing countries haveslowed in the past several decades, globalizers have shown exactly the oppo-site trend, with their growth accelerating during the 1970s and 1980s. Theauthors’ selection of globalizers and the procedure for calculating changes intariffs and trade shares can be criticized as either inappropriate (for exam-ple, trade shares represent outcomes of policies and not policies themselves)or faulty. Yet, the fact that the post-1980 globalizers, which were initiallypoorer and had similar levels of educational attainments and inflation in1980 as the nonglobalizers, were able to surpass their counterparts in allthese dimensions by 1997, is consistent with the hypothesis that their tradeinduced the faster growth that enabled them to do so.

19

Jeffrey Frankel and David Romer (1999) have published a study that,unlike the others that concentrate on trade and growth, examines the rela-tion between openness and per capita income. Recognizing that the oppor-tunity to trade can potentially increase the income of both trading parties,the authors postulate that income per capita is a positive function of do-mestic and international trade. Domestic trade, on which there are no data,is viewed as being determined by country size (population and land area).Endogeneity of international trade (defined as the share of trade in GDP) isaddressed by replacing actual trade with predicted trade based on a gravitymodel. The results show that endogeneity of trade is not a serious problemand that trade has a quantitatively large and robust, though only moder-ately significant, positive effect on income. In addition to the fact that thisstudy says nothing about the growth effects of openness to trade, it is silentabout the mechanisms through which trade as a share of GDP influencesthe level of per capita income.

It is interesting, and suggestive, that vast numbers of regression analyseshave supported the notion that openness to trade is associated with higherincomes and growth rates. I am wary, however, of drawing firm conclusionsfrom cross-country regressions, especially in light of my foregoing criticisms(see Srinivasan 1999, p. 67). Although such regressions may suggest newhypotheses and may be valuable aids for thinking about the issue at hand,great caution is needed in using them at all as plausible, “scientific,” sup-port. The same caution is needed in using the regressions of Rodriguez andRodrik (1999) as scientific critiques of other regressions. This is particularlytrue because the regressions (and the conclusions based on them) are likelyto be critically dependent on the period, the sample of countries, and thevariables chosen. In fact, given these numerous choices, one can confidentlyexpect that there are enough de facto degrees of freedom at an analyst’scommand to reverse any “findings” arrived at by another analyst usingsimilar regression methods. Using these cross-country-regression methodsto argue the case for openness to trade, when nuanced and in-depth studiesare much more persuasive, is to create the wrong impression that the casefor openness to trade is illusory. The case continues to be strong, and itwould be tragic, indeed, if developing countries ignore it.

In much of the recent literature on growth, the focus has been on thesteady-state properties. This can be very misleading. Appendix B considersa two-sector (capital-goods and consumption-goods) neoclassical growthmodel. It uses a numerical example to show that per worker consumptionin the autarky steady state can be higher than in the free-trade steady state,in which the economy is specialized in the production of consumer goods.Does this mean that it is not optimal for an economy in its autarky steadystate to adopt free trade when the opportunity to do so arises, because

20

consumption per worker is lower at its free-trade steady state? The answeris clearly no.

The reason is simple. As Srinivasan and Bhagwati (1980) argue, oncethe economy adopts free trade, along the transition to the free-trade steadystate, per worker consumption rises above its autarky steady-state levelfor an initial interval of time, before declining and converging to the lowerfree-trade steady-state level. The gain in the discounted sum of felicitiesrelative to the autarky steady state during this interval exceeds the lossin the subsequent period of decline in per worker consumption. Thus, thediscounted sum of felicities along the free-trade growth path exceeds thatalong the autarky steady-state path. Free trade, therefore, is indeed theoptimal dynamic policy for a small open economy.

21

Appendix A: The Mahalanobis Model

The Consumption-Goods Sector

Output of good i = Qci (i = 1, 2); domestic use of good i = Cc

i (i = 1, 2);stock of capital = Kc

Production frontier β1Qc1 + β2Q

c2 = Kc (A.1)

Utility function U = (Cc1)

α(Cc2)

1−α (A.2)

The Investment-Goods Sector

Output of good i = QIi (i = 1, 2); domestic use of good i = AI

i (i = 1, 2);stock of capital = KI

Production frontier γ1QI1 + γ2Q

I2 = KI (A.3)

Aggregate investment I =(AI

1

)δ (AI

2

)1−δ (A.4)

Capital Accumulation

Let λ be the share of investment devoted to the accumulation of KI . Then,

KI =dKI

dt= λI , (A.5)

Kc =dKc

dt= (1− λ)I . (A.6)

Autarky

Cci = Qc

i and AIi = QI

i for i = 1, 2 .

Maximization of (A.2) subject to (A.1) leads to

Cc1 =

αKc

β1

, Cc2 =

(1− α)Kc

β2

and U =

(α

β1

)α(1− α

β2

)1−α

Kc . (A.7)

22

Maximization of (A.4) subject to (A.3) leads to

AIi =

δKI

γ1

, AI2 =

(1− δ)KI

γ2

. (A.8)

Substituting (A.8) in (A.4), one gets

I =

(δ

γ1

)δ (1− δ

γ2

)1−δ

KI (A.9)

≡ ηKI where η =

(δ

γ1

)δ (1− δ

γ2

)1−δ

. (A.9′)

Using (A.9′) in (A.5) and (A.6) and solving:

KI = KI0e

ληt , (A.10)

Kc = Kc0 +

(1− λ

λ

)KI

0

(eληt

). (A.11)

Thus, the long-run growth rates of KI ,Kc, I, and U are the same and equalto λη.

Free Trade in Consumer Goods at a Relative Price of πc of Good 2 in

Terms of Good 1 and Autarky in Investment Goods

Without loss of generality, assume πc > β2/β1. It is then optimal toproduce only Good 2 and to import Good 1. It is easy to show that

Qc1 = 0, Qc

2 = Kc/β2, Cc1 = απcKc/β2 ,

andU = αa(1− α)1−α(πc)αKc/β2 .

It is easy to verify that given πc > β2/β1, U is higher than under autarkyfor any Kc. Because the investment-goods sector is closed to trade, thedynamics of the system are unaffected, so that the paths of KI and Kc

continue to be given by (A.10) and (A.11), respectively. Thus, the long-run

23

growth rates Kc, II , and U are still λη, although the level of U at each t ishigher than under autarky.

Free Trade in Investment Goods at a Relative Price of πI of Good 2 in

Terms of Good 1 and Autarky in Consumption Goods

Without loss of generality, assume πI > γ2/γ1. It is then optimal to pro-duce only Good 2, to export part of the output, and to import Good 1.

It is easy to show that

QI1 = 0, QI

2 = KI/γ2, AI2 = δπIKI/γ2, AI

2 = [(1− δ)KI ]/γ2 ,

andI = δδ(1− δ)δ(KI/γ2) .

It is easy to verify that given πI > γ2γ2, investment under free trade ishigher than under autarky for any KI .

Using (A.5) and (A.6) and solving, one gets

KI = KI0e

λµt µ = [δδ(1− δ)(1−δ)(πI)δ]/γ2

and

Kc = Kc0 +

(1− λ

λ

)KI

0eλµt .

Given πI >(

γ2

γ1

), it follows that µ > η.

Thus, the values of KI and Kc at each time t under free trade in invest-ment goods are higher than their corresponding values under autarky. Thecommon long-run growth rates of KI ,Kc, and I, namely, λµ, are alsohigher than their value λη under autarky. Because the consumption-goodssector is under autarky,

Qc = Cc1 = αKc/β1, Qc

2 = Cc2 = [(1− α)Kc]/β2 ,

andU = (α/β1)

α[(1− α)/β2]

1−αKc .

Because Kc at each t under free trade in investment goods is higher thanunder autarky, U is higher as well. Because Kc grows faster, U also growsfaster.

24

Appendix B: The Two-Sector Neoclassical Growth Model

Let the average physical product of labor in the investment-goods sector befI(kI), where kI is the capital-labor ratio. Let the corresponding functionin the consumption-goods sector be fc(kc), where kc is the capital-laborratio in that sector. The aggregate capital-labor endowment ratio k is

k = lckc + (1− lc) kI , (B.1)

where lc is the share of the labor force employed in the production of con-sumer goods. In any competitive equilibrium in which both goods areproduced in positive amounts, the wage-rental ratio ω equals the marginalrate of substitution between capital and labor in each sector, that is,

ω =fI(kI)− kIf

′

I(kI)

f ′

I(kI)=

fc(kc)− kcf′

c(kc)

f ′

c(kc). (B.2)

Assuming, for simplicity, fI(kI) = kβI , fc(kc) = kαc ,

ω =

(1− β

β

)kI =

(1− α

α

)kc . (B.3)

Assume that β > α, so that kI > kc at all ω, that is, that the investment-goods sector is capital intensive.

In an autarky steady state, both goods have, by definition, to be produced.Therefore, using superscript A to denote autarky and an asterisk to denotethe steady state,

k∗AI =

(β

1− β

)ω∗A, k∗Ac =

(α

1− α

)ω∗A . (B.4)

The fact that the economy is in the optimal autarky steady state impliesthat the marginal physical product of capital in the capital-goods sectorequals n+ δ + ρ, where n is the rate of growth of the labor force, δ is theexponential depreciation rate of capital, and ρ is the felicity discount rate.Thus,

β(k∗AI

)β−1= (n+ δ + ρ) ,

25

or

k∗AI =

(β

n+ δ + ρ

) 1

1−β

. (B.5)

Using (B.3),

k∗Ac =

[α (1− β)

β(1− α)

]k∗AI , (B.6)

and

ω∗A =

(1− β

β

)k∗AI . (B.7)

The price p∗A of consumption goods in terms of investment goods in theautarky steady state is given by the ratio of marginal physical productof capital (or labor) in the capital-goods sector to its marginal physicalproduct in the consumption-goods sector. Thus,

p∗A =β(k∗AI

)β−1

α (k∗Ac )α−1 =

β

α

[α(1− β)

β(1− α)

]1−α(β

n+ δ + ρ

)β−α

. (B.8)

Denoting by k∗A the aggregate capital-labor ratio and by l∗Ac the share ofemployment in the consumption-goods sector, and noting that along thesteady state, the output of investment goods per worker must equal whatis needed to replace depreciating capital and keep the capital-labor ratioconstant, we get

k∗A = l∗Ac k∗Ac +(1− l∗Ac

)k∗AI , (B.9)

(1− l∗c )(k∗AI

)β= (n+ δ)k∗A . (B.10)

Eliminating l∗Ac between (B.9) and (B.10) yields

k∗A =

(k∗Ac

) (k∗AI

)β(k∗AI

)β− (n+ δ)

(k∗AI − k∗Ac

) . (B.11)

26

If we set α = 0.25, β = 0.5, n = 0.02, δ = 0.03, and ρ = 0.05, then,

k∗AI = 52 = 25, k∗Ac =25

3,

ω∗A = 25, p∗A = 2

(1

3

)0.75

50.25 � 1.3120 ,

k∗A =

(253

)(25)

0.5

(25)0.5 − .05(25− 25

3

) =125

3[5− 2.5

3

] = 10 ,

l∗Ac =k∗AI − k∗A

k∗AI − k∗Ac=

25− 10

25− 253

= 0.9 .

Consumption per worker c∗A in autarky steady state is given by

c∗A = l∗Ac(k∗Ac

)α= 0.9

(25

3

)0.25

� 1.5291 .

Suppose an opportunity arises to trade with the rest of the world at aprice pT = 2 of consumption goods in terms of investment goods. It canbe shown that in its free-trade steady state, the economy will specializein consumption goods. Its aggregate capital-labor ratio in the free steadystate k∗T , which is also the capital-labor ratio in the production of consumergoods, will equal

k∗T = k∗Tc � 8.5499 .

This follows from the fact that the marginal-value product of capital (interms of investment) must equal n+ δ + ρ in the steady state or

pTα(k∗Tc

)α−1= (n+ δ + ρ) ,

so that

k∗Tc =

(αpT

n+ δ + ρ

) 1

1−α

=

(0.5

0.1

) 4

3

= (5)4

3 = 8.5499 .

27

The steady-state level c∗T of consumption per worker is given by the differ-ence between the output of consumption goods per worker (k∗T )α and theexport of consumption goods needed to finance the imports of investmentgoods to maintain capital per worker at k∗T , that is, (n+ δ)k∗T /pT . Thus,

c∗T = (k∗T )α − (n+ δ)k∗T

pT= (8.5499)

1

4 −0.05× 8.5499

2

= 1.4962 < c∗A .

Starting from the autarky steady state with an aggregate-capital-labor ra-tio of 10, at the instant trade opens at price pT = 2 > pA = 1.3125,the economy can be shown to be initially incompletely specialized, using acapital-labor ratio of 9 (instead of the autarky value of 8.33) in the pro-duction of consumption goods, and of 27 (instead of the autarky value of25) in the production of investment goods. However, the share of labordevoted to the production of consumer goods increases to 0.94 (comparedto its autarky value of 0.9). Because the aggregate-capital-labor ratio inthe free-trade steady state of 8.5499 is below its initial (autarky) value of10, the economy does not have to invest (in gross terms) as much under freetrade as under autarky. Thus, for three reasons–a higher capital-labor ra-tio, a higher share of employment in the production of consumption goods,and a lower gross investment per worker–consumption initially rises aboveits autarky value.

28

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32

FRANK D. GRAHAM MEMORIAL LECTURERS

1950–1951 Milton Friedman 1998–1999 Jeffrey A. Frankel (Essay 215)1951–1952 James E. Meade 1999–2000 T. N. Srinivasan (Essay 225)1952–1953 Sir Dennis Robertson1953–1954 Paul A. Samuelson1955–1956 Gottfried Haberler1956–1957 Ragnar Nurkse1957–1958 Albert O. Hirschman1959–1960 Robert Triffin1960–1961 Jacob Viner1961–1962 Don Patinkin1962–1963 Friedrich A. Lutz (Essay 41)1963–1964 Tibor Scitovsky (Essay 49)1964–1965 Sir John Hicks1965–1966 Robert A. Mundell1966–1967 Jagdish N. Bhagwati (Special Paper 8)1967–1968 Arnold C. Harberger1968–1969 Harry G. Johnson1969–1970 Richard N. Cooper (Essay 86)1970–1971 W. Max Corden (Essay 93)1971–1972 Richard E. Caves (Special Paper 10)1972–1973 Paul A. Volcker1973–1974 J. Marcus Fleming (Essay 107)1974–1975 Anne O. Krueger (Study 40)1975–1976 Ronald W. Jones (Special Paper 12)1976–1977 Ronald I. McKinnon (Essay 125)1977–1978 Charles P. Kindleberger (Essay 129)1978–1979 Bertil Ohlin (Essay 134)1979–1980 Bela Balassa (Essay 141)1980–1981 Marina von Neumann Whitman (Essay 143)1981–1982 Robert E. Baldwin (Essay 150)1983–1984 Stephen Marris (Essay 155)1984–1985 Rudiger Dornbusch (Essay 165)1986–1987 Jacob A. Frenkel (Study 63)1987–1988 Ronald Findlay (Essay 177)1988–1989 Michael Bruno (Essay 183)1988–1989 Elhanan Helpman (Special Paper 16)1989–1990 Michael L. Mussa (Essay 179)1990–1991 Toyoo Gyohten1991–1992 Stanley Fischer1992–1993 Paul Krugman (Essay 190)1993–1994 Edward E. Leamer (Study 77)1994–1995 Jeffrey Sachs1995–1996 Barry Eichengreen (Essay 198)1996–1997 Wilfred J. Ethier (Essay 210)1997–1998 Maurice Obstfeld (Essay 209)

33

PUBLICATIONS OF THEINTERNATIONAL ECONOMICS SECTION

Notice to ContributorsThe International Economics Section publishes papers in two series. ESSAYS ININTERNATIONAL ECONOMICS and PRINCETON STUDIES IN INTERNATIONAL ECO-NOMICS. Two earlier series, REPRINTS IN INTERNATIONAL FINANCE and SPECIALPAPERS IN INTERNATIONAL ECONOMICS, have been discontinued, with the SPECIALPAPERS being absorbed into the STUDIES series.

The Section welcomes the submission of manuscripts focused on topics in inter-national trade, international macroeconomics, or international finance. Submissionsshould address systemic issues for the global economy or, if concentrating onparticular economies, should adopt a comparative perspective.

ESSAYS IN INTERNATIONAL ECONOMICS are meant to disseminate new views aboutinternational economic events and policy issues. They should be accessible to a broadaudience of professional economists.

PRINCETON STUDIES IN INTERNATIONAL ECONOMICS are devoted to new researchin international economics or to synthetic treatments of a body of literature. Theyshould be comparable in originality and technical proficiency to papers published inleading economic journals. Papers that are longer and more complete than thosepublishable in the professional journals are welcome.

Manuscripts should be submitted in triplicate, typed single sided and doublespaced throughout on 8½ by 11 white bond paper. Publication can be expedited ifmanuscripts are computer keyboarded in WordPerfect or a compatible program.Additional instructions and a style guide are available from the Section or on thewebsite at www.princeton.edu/~ies.

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International Economics SectionDepartment of Economics, Fisher HallPrinceton UniversityPrinceton, New Jersey 08544-1021Tel: 609-258-4048 • Fax: 609-258-1374E-mail: ies@princeton.edu

35

List of Recent Publications

A complete list of publications is available at the International Economics Sectionwebsite at www.princeton.edu/~ies.

ESSAYS IN INTERNATIONAL ECONOMICS

(formerly Essays in International Finance)

185. Ethan B. Kapstein, Supervising International Banks: Origins and Implicationsof the Basle Accord. (December 1991)

186. Alessandro Giustiniani, Francesco Papadia, and Daniela Porciani, Growth andCatch-Up in Central and Eastern Europe: Macroeconomic Effects on WesternCountries. (April 1992)

187. Michele Fratianni, Jürgen von Hagen, and Christopher Waller, The MaastrichtWay to EMU. (June 1992)

188. Pierre-Richard Agénor, Parallel Currency Markets in Developing Countries:Theory, Evidence, and Policy Implications. (November 1992)

189. Beatriz Armendariz de Aghion and John Williamson, The G-7’s Joint-and-Several Blunder. (April 1993)

190. Paul Krugman, What Do We Need to Know about the International MonetarySystem? (July 1993)

191. Peter M. Garber and Michael G. Spencer, The Dissolution of the Austro-Hungarian Empire: Lessons for Currency Reform. (February 1994)

192. Raymond F. Mikesell, The Bretton Woods Debates: A Memoir. (March 1994)193. Graham Bird, Economic Assistance to Low-Income Countries: Should the Link

be Resurrected? (July 1994)194. Lorenzo Bini-Smaghi, Tommaso Padoa-Schioppa, and Francesco Papadia, The

Transition to EMU in the Maastricht Treaty. (November 1994)195. Ariel Buira, Reflections on the International Monetary System. (January 1995)196. Shinji Takagi, From Recipient to Donor: Japan’s Official Aid Flows, 1945 to

1990 and Beyond. (March 1995)197. Patrick Conway, Currency Proliferation: The Monetary Legacy of the Soviet

Union. (June 1995)198. Barry Eichengreen, A More Perfect Union? The Logic of Economic Integration.

(June 1996)199. Peter B. Kenen, ed., with John Arrowsmith, Paul De Grauwe, Charles A. E.

Goodhart, Daniel Gros, Luigi Spaventa, and Niels Thygesen, Making EMUHappen—Problems and Proposals: A Symposium. (August 1996)

200. Peter B. Kenen, ed., with Lawrence H. Summers, William R. Cline, BarryEichengreen, Richard Portes, Arminio Fraga, and Morris Goldstein, From Halifaxto Lyons: What Has Been Done about Crisis Management? (October 1996)

201. Louis W. Pauly, The League of Nations and the Foreshadowing of the Interna-tional Monetary Fund. (December 1996)

202. Harold James, Monetary and Fiscal Unification in Nineteenth-Century Germany:What Can Kohl Learn from Bismarck? (March 1997)

203. Andrew Crockett, The Theory and Practice of Financial Stability. (April 1997)

36

204. Benjamin J. Cohen, The Financial Support Fund of the OECD: A FailedInitiative. (June 1997)

205. Robert N. McCauley, The Euro and the Dollar. (November 1997)206. Thomas Laubach and Adam S. Posen, Disciplined Discretion: Monetary Target-

ing in Germany and Switzerland. (December 1997)207. Stanley Fischer, Richard N. Cooper, Rudiger Dornbusch, Peter M. Garber,

Carlos Massad, Jacques J. Polak, Dani Rodrik, and Savak S. Tarapore, Shouldthe IMF Pursue Capital-Account Convertibility? (May 1998)

208. Charles P. Kindleberger, Economic and Financial Crises and Transformationsin Sixteenth-Century Europe. (June 1998)

209. Maurice Obstfeld, EMU: Ready or Not? (July 1998)210. Wilfred Ethier, The International Commercial System. (September 1998)211. John Williamson and Molly Mahar, A Survey of Financial Liberalization.

(November 1998)212. Ariel Buira, An Alternative Approach to Financial Crises. (February 1999)213. Barry Eichengreen, Paul Masson, Miguel Savastano, and Sunil Sharma,

Transition Strategies and Nominal Anchors on the Road to Greater Exchange-Rate Flexibility. (April 1999)

214. Curzio Giannini, “Enemy of None but a Common Friend of All”? An Interna-tional Perspective on the Lender-of-Last-Resort Function. (June 1999)

215. Jeffrey A. Frankel, No Single Currency Regime Is Right for All Countries or atAll Times. (August 1999)

216. Jacques J. Polak, Streamlining the Financial Structure of the InternationalMonetary Fund. (September 1999)

217. Gustavo H. B. Franco, The Real Plan and the Exchange Rate. (April 2000)218. Thomas D. Willett, International Financial Markets as Sources of Crises or

Discipline: The Too Much, Too Late Hypothesis. (May 2000)219. Richard H. Clarida, G-3 Exchange-Rate Relationships: A Review of the Record

and of Proposals for Change. (September 2000)220. Stanley Fischer, On the Need for an International Lender of Last Resort.

(November 2000)221. Benjamin J. Cohen, Life at the Top: International Currencies in the Twenty-

First Century. (December 2000)222. Akihiro Kanaya and David Woo, The Japanese Banking Crisis of the 1990s:

Sources and Lessons. (June 2001)223. Yung Chul Park, The East Asian Dilemma: Restructuring Out or Growing Out?

(August 2001)224. Felipe Larrain B. and Andrés Velasco, Exchange-Rate Policy in Emerging-

Market Economies. (December 2001)225. T. N. Srinivasan, Trade, Development, and Growth. (December 2001)

PRINCETON STUDIES IN INTERNATIONAL ECONOMICS

(formerly Princeton Studies in International Finance)

72. George M. von Furstenberg and Joseph P. Daniels, Economic Summit Decla-rations, 1975-1989: Examining the Written Record of International Coopera-tion. (February 1992)

37

73. Ishac Diwan and Dani Rodrik, External Debt, Adjustment, and Burden Sharing:A Unified Framework. (November 1992)

74. Barry Eichengreen, Should the Maastricht Treaty Be Saved? (December 1992)75. Adam Klug, The German Buybacks, 1932-1939: A Cure for Overhang?

(November 1993)76. Tamim Bayoumi and Barry Eichengreen, One Money or Many? Analyzing the

Prospects for Monetary Unification in Various Parts of the World. (September 1994)77. Edward E. Leamer, The Heckscher-Ohlin Model in Theory and Practice.

(February 1995)78. Thorvaldur Gylfason, The Macroeconomics of European Agriculture. (May 1995)79. Angus S. Deaton and Ronald I. Miller, International Commodity Prices, Macro-

economic Performance, and Politics in Sub-Saharan Africa. (December 1995)80. Chander Kant, Foreign Direct Investment and Capital Flight. (April 1996)81. Gian Maria Milesi-Ferretti and Assaf Razin, Current-Account Sustainability.

(October 1996)82. Pierre-Richard Agénor, Capital-Market Imperfections and the Macroeconomic

Dynamics of Small Indebted Economies. (June 1997)83. Michael Bowe and James W. Dean, Has the Market Solved the Sovereign-Debt

Crisis? (August 1997)84. Willem H. Buiter, Giancarlo M. Corsetti, and Paolo A. Pesenti, Interpreting the

ERM Crisis: Country-Specific and Systemic Issues. (March 1998)85. Holger C. Wolf, Transition Strategies: Choices and Outcomes. (June 1999)86. Alessandro Prati and Garry J. Schinasi, Financial Stability in European Economic

and Monetary Union. (August 1999)87. Peter Hooper, Karen Johnson, and Jaime Marquez, Trade Elasticities for the

G-7 Countries. (August 2000)88. Ramkishen S. Rajan, (Ir)relevance of Currency-Crisis Theory to the Devaluation

and Collapse of the Thai Baht. (February 2001)89. Lucio Sarno and Mark P. Taylor, The Microstructure of the Foreign-Exchange

Market: A Selective Survey of the Literature. (May 2001)

SPECIAL PAPERS IN INTERNATIONAL ECONOMICS

17. Richard Pomfret, International Trade Policy with Imperfect Competition. (August1992)

18. Hali J. Edison, The Effectiveness of Central-Bank Intervention: A Survey of theLiterature After 1982. (July 1993)

19. Sylvester W.C. Eijffinger and Jakob De Haan, The Political Economy of Central-Bank Independence. (May 1996)

20. Olivier Jeanne, Currency Crises: A Perspective on Recent Theoretical Develop-ments. (March 2000)

REPRINTS IN INTERNATIONAL FINANCE

29. Peter B. Kenen, Sorting Out Some EMU Issues; reprinted from Jean MonnetChair Paper 38, Robert Schuman Centre, European University Institute, 1996.(December 1996)

38

The work of the International Finance Section is supportedin part by the income of the Walker Foundation, establishedin memory of James Theodore Walker, Class of 1927. Theoffices of the Section, in Fisher Hall, were provided by agenerous grant from Merrill Lynch & Company.

ISBN 0-88165-132-XRecycled Paper