Working Paper: NBER ID: w2449
Authors: Charles Engel; Kenneth Kletzer
Abstract: Because trade liberalization which is anticipated to be temporary creates a divergence between the effective domestic rate of interest and the world rate of interest, tariff-reduction in the presence of international financial asset trade may reduce welfare for a small country. Calvo has argued that even though the government intends to liberalize trade permanently, if the private sector believes with some probability that a tariff will be imposed in the future, then free trade may not be optimal. This paper first formalizes this argument and discusses the optimal policy for a government which seeks to maximize representative household welfare. The government's lack of credibility is represented by a set of beliefs the private sector holds about the type of government it faces. Next, beliefs are endoqenized by allowing me private sector to update them using Bayes' rule. In one approach, the true government's objective is maximize welfare for the economy, so that it does not seek to imitate another type, in contrast with other recent models of policy credibility. With learning, the government eventually adopts free trade, even though restricted trade is optimal initially.
Keywords: trade policy; endogenous credibility; welfare outcomes; Bayesian updating
JEL Codes: F13; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government credibility (H12) | household welfare (I38) |
| lack of government credibility (H12) | optimal trade policy (F13) |
| beliefs of private sector regarding government type (P16) | consumption decisions (D12) |
| beliefs of private sector regarding government type (P16) | saving decisions (D14) |
| government actions (H59) | household expectations (D19) |
| government actions (H11) | welfare outcomes (I38) |
| trade liberalization anticipated to be temporary (F69) | divergence between domestic and world interest rates (E43) |
| divergence between domestic and world interest rates (E43) | potential welfare reduction for a small country (D69) |
| private sector beliefs about government type (H10) | optimality of free trade (F10) |
| learning (C91) | skepticism in private sector for tariffs to be superior to free trade (F13) |
| lack of government credibility (H12) | intertemporal distortion (D15) |
| intertemporal distortion (D15) | suboptimal policy choices (D78) |
| learning (C91) | weakening case for tariffs (F69) |
| learning (C91) | optimality of free trade over time (F11) |