Working Paper: NBER ID: w18703
Authors: Nuno Limão; Giovanni Maggi
Abstract: In this paper we explore the potential gains that a trade agreement (TA) can provide by regulating trade-policy uncertainty, in addition to the more standard gains from reducing the mean levels of trade barriers. We show that in a standard trade model with income-risk neutrality there tends to be an uncertainty- increasing motive for a TA. With income-risk aversion, on the other hand, the uncertainty-managing motive for a TA is determined by interesting trade-offs. For a given degree of risk aversion, an uncertainty- reducing motive for a TA is more likely to be present when the economy is more open, the export supply elasticity is lower and the economy is more specialized. Governments have stronger incentives to sign a TA when the trading environment is more uncertain. As exogenous trade costs decline, the gains from decreasing trade-policy uncertainty tend to become more important relative to the gains from reducing average trade barriers. We also derive simple "sufficient statistics" to determine the direction of the uncertainty motive for a TA and the associated welfare gains, and we apply them to the trading relationship between US and Cuba before 1934. Finally, we examine how the uncertainty motive for a TA is affected by the presence of ex-ante investments, and examine conditions under which an uncertainty-reducing TA will increase investment in the export sector.
Keywords: trade agreements; policy uncertainty; risk aversion; economic shocks
JEL Codes: F1; F13; F5; F6; O19
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| income-risk neutrality (D11) | uncertainty-increasing motive for trade agreement (D89) |
| income-risk aversion (D11) | uncertainty-reducing motive for trade agreement (D80) |
| openness (O36) | uncertainty-reducing motive for trade agreement (D80) |
| export supply elasticity (F10) | uncertainty-reducing motive for trade agreement (D80) |
| economy specialization (P19) | uncertainty-reducing motive for trade agreement (D80) |
| declining trade costs (F12) | incentives for governments to engage in trade agreements (F13) |
| uncertainty-reducing trade agreement (F13) | increased investment in the export sector (O24) |