Which best captures the impact of high tariffs on some goods imported into the economy?

The Trade Balance and Capital Flows

The terms of trade, T, is defined as the price of one country’s exports in terms of the other (say the price of wine in terms of cheese). In our earlier installment of the global perspective, we showed that when the terms of trade do not change, the interest rate parity (IRP) and PPP hold at all times and the real rate of returns is equalized across countries. Under this scenario, there is no need for global investing. One can get the same rate of return at home as one can get elsewhere. A more interesting case is one where the terms of trade are changing.

A favorable term of trade change to Lakeland means that a pound of cheese is now able to get a larger quantity of wine. Another way of saying the same thing is that the rate of return earned by producing cheese increases relative to the rate of return earned in the production of wine. The question is how we modify our analysis to account for the change in terms of trade. We do so in the below equation:

(9.5)ρl=ρw+τ

where τ denotes the change in terms of trade between the two economies.

Combining the two versions of IRP developed in our earlier installment of the global framework, we obtain the following relationships:

il−iw=Є=πl−πw−ρl−ρw

Substituting Eq. (9.5) into the previous equation yields:

(9.5′)il−iw=Є=πl−πw+τ

Rearranging the terms, we get an expression for the changes in terms of trade:

(9.6)τ=Є−πl−πw

This equation provides the following insight: violations of PPP reflect changes in the terms of trade of an economy. A terms of trade appreciation over and above the nominal exchange rate appreciation. Or the real exchange rate reflects an increase in the real rate of return of the exported and exportable products relative to the other economies’ exported products, as well as the import competing products at home.

To summarize, it is the deviations from PPP that reflect the terms of trade changes and the corresponding rates of return differentials across countries. Therefore if devaluation is to have a real effect on the economy, that is alter the price of imports in terms of exports, it must generate deviations from PPP. We contend that only real variables or variables that affect the real economy, such as tax rates or technological changes, can cause changes in the exchange rate over and above the PPP fluctuations. Thus netting the inflation rate differential from the exchange rate changes gives us an estimate of the countries’ terms of trade changes

What Drives the Nominal Exchange Rate?

The previous equation identifies two distinct sources regarding what drives the nominal exchange rate: The terms of trade and inflation rate differential between the two countries.

How the inflation rate differential affects the nominal exchange rate has already been discussed. In a world where there are no transportation costs and goods and factors are perfectly mobile, arbitrage will insure that there are no profits opportunities. That will only be the case if the dollar price of every commodity is the same across the world. That is the PPP proposition.

The terms of trade effects are somewhat different. An improvement in the terms of trade in one country means that the nontraded good can now buy more of the traded commodity. The terms of trade have two distinct effects in the country. One is a net wealth effect that leads to an increase in the aggregate demand for goods and services. The other, terms of trade effect, are that an improving terms of trade means that the rate of return of producing the nontraded commodity rises.

As a result of the increased rates of return, capital and other factors will be attracted from the traded sectors both at home, as well as the rest of the world. As factors of production move from the traded sector, the global traded goods production both at home and abroad tends to decline. The increased domestic demand and decline in domestic production of the traded good means that the country’s trade balance will decline. The increased domestic demand for the traded good combined with the increase in demand from the rest of the world means an increase in the world’s aggregate demand, and the world price for the current consumption of traded goods vis-a-vis the future will unambiguously increase. That will induce a common effect on output across the different economies. World income and the various national productions of the traded goods will tend to rise by the same proportion.

The increase in the global demand for the traded goods will attract resources form the nontraded sectors in the rest of the world. The end result being that the rising price of the traded goods will induce a common effect on all the countries’ GDPs. However, the story with the nontraded sector is a bit different. The rates of return in the nontraded sector will rise above that of the traded goods. In the other country, the opposite will happen; the rate of return will rise by less than that of the traded sector.

Notice that, we have assumed here an initial aggregate demand shock that increases local demand. If instead, we had assumed an aggregate supply shock that increases local supply, effect on the trade balance would be different. Yet even under these circumstances, we would expect the country with the aggregate supply shift to improve its growth rate and profitability relative to the rest of the world. Hence, we would expect the stock market to improve its relative performance.

In conclusion, the terms of trade effect result in:

A deterioration of the trade balance of the country where the aggregate demand shock produces a favorable terms of trade effect.

An increase in the global output with the country with the favorable terms of trade effect, experiencing an above-average percentage increase, while the country experiencing the adverse terms of trade effect posting a below-average percentage increase.

The country with the favorable terms of trade experiences an above-average rate of return, while the country with the adverse terms of trade experiences a below-average rate of return.

What Happens When the Terms of Trade Change in Predictable Directions?

The terms of trade, T, is defined as the price of one country’s exports in terms of the other (say the price of wine in terms of cheese). A change in the terms of trade means that for the economy with the more favorable terms of trade, say Lakeland, a pound of cheese is now able to get a larger quantity of wine. This means that the rate of return earned by producing cheese increases relative to the rate of return earned in the production of wine. As a result Eq. (1.21) has to be modified to account for the change in terms of trade. In dynamic form the terms of trade equation now becomes:

(1.22)ρl=ρw+τ

Where τ denotes the change in terms of trade between the two economies.

The combining of Eqs. (1.17) and (1.20), yields the following relationships:

il−iw=Є=π l−πw+(ρl−ρw)

Substituting Eq. (1.22) into the previous equation yields:

i1−iw=Є=π1−πw+τ

Rearranging the terms we get an expression for the changes in terms of trade:

(1.23)τ=Є−(πl−πw)

This equation provides an interesting insight: violations of PPP reflect changes in the terms of trade of an economy.

The change in the terms of trade is measured as an appreciation of the exchange rate over and above the inflation rate differential between the two currencies. It reflects an increase in the real rate of return of an economy relative to the real rate of return of the other economy.

The Real Exchange Rate or Terms of Trade Appreciation has a Secondary Effect on the Economy: The higher real rate of return means that one pound of cheese in the earlier example can now buy more bottles of wine. This induces people in Lakeland to devote more resources to cheese production at the expense of wine production. These forces will also be at work in Westland, where resources will now be diverted from wine production to the production of the import substitution good: domestic cheese. Therefore, cheese production worldwide increases, while wine production unambiguously declines.

The higher rate of return also means that the resources that are intensive in the production of the appreciating good, say pasture land, experiences an increase in valuation, while the factors intensive in the production of wine decline in value [10]. Cheese land appreciates relative to wine land. Given the assumption that Lakeland is intensive in cheese land relative to Westland, we expect to see the Lakeland stock market outperform the Westland stock market.

The Terms of Trade Analysis is Simple and Straightforward: When a commodity’s relative prices remain unchanged, for example, when the price of cheese in terms of wine remains unchanged, so do the terms of trade. In that case, arbitrage ensures that PPP, holds and real rates of return are equalized across countries. Under PPP, the exchange rate changes only reflect inflation rate differentials across countries.

Now if PPP does not hold, then the deviations from PPP reflect relative price changes. For example, when the price of cheese in terms of wine increases, that is, terms of trade changes, the country which experiences currency appreciation over and above the inflation rate differential, Lakeland, will also experience a stock market appreciation relative to its trading partner, Westland.

The increase in real rate of return diverts capital from wine production to cheese production in both countries, Lakeland and Westland. Therefore global production and employment in the cheese industry will increase, while wine production and employment in the wine industry decreases.

5.3.6 Terms of Trade

The terms of trade is measured by the ratio between the prices of exported and imported goods. An increase, or an improvement, in the terms of trade, therefore, means that there has been an increase in the average price of exported products in relation to imported. To study the effect of the terms of trade, it is necessary to distinguish the tradable goods between those that are exported and those that are imported. We will then have three goods in the economy: exportables, importables, and nontradables. The production possibilities frontier becomes17

[(XaX)ρ+(MaM)ρ+(NaN )ρ]1ρ=Y¯.

Solving the producer problem of GDP maximization, subject to the production possibilities frontier in the previous equation, we have that the supply of each of the goods can be written as18

(5.43)X=Y¯(pXaTρ∏¯(pN))1ρ−1,M=Y¯(aTρ∏¯(pN ))1ρ−1,N=Y¯(pNaNρ∏¯ (pN))1ρ−1,

where Π¯(pN)≡[(pXaN)ρρ−1+ aTρρ−1+(pNaN)ρρ−1]ρ−1ρ, and pX is the price of exportable goods. Notice that we take the price of the importable good as being equal to one, so that pX corresponds to the term of trade, that is, the price of the exportable good in relation to the importable.

The equilibrium price of the nontradables, which was given by Eq. (5.21), is now determined by

pNt=(α1−α)[(1+i *)(pXX1+M1) +(pXX2+M2)Nt(2+i*)],

where we assume that the price of exportable goods is the same for both periods. Using the supply functions (5.43), the previous equation can be written as

(5.44)pNt=pN=[(pXaN)ρρ−1+(aM)ρ−1ρ]ρ−1ρaN(α1−α)ρ−1ρ,

assuming that the production possibilities frontier parameters do not change over time, as we did in the previous section.

To simplify the analysis, let us assume there are only two countries: the home country and the foreign. The consumer preferences are identical in the two countries, but they differ in relation to the production possibilities frontier parameters. More specifically, they differ in the productivity parameters.

In the foreign country, the price of nontradables is given by

(5.45)pN*=[(pXa)ρρ−1+(aM*)ρ−1ρ]ρ−1ρaN*(α1−α)ρ−1ρ.

Notice that in the foreign country, good X is imported, and good M is exported. For the home country to export good X and import good M, it needs to have a comparative advantage in the production of good X: its production of X should be relatively greater than the production of M in relation to the foreign country.19 Stated differently, it is necessary that

(5.46)aXa M>aX*aM*.

As we will see, this relation is essential to identify the effect of terms of trade variations on the RER.

Substituting the prices of nontradables in the two countries, Eqs. (5.44) and (5.45), into the RER equation (5.3), we have that20

(5.47) Q=[(pX aX*)ρρ−1+(aM*)ρ−1ρ(pXaX)ρρ−1+ (aM)ρ−1ρ] ρ−1ρaNaN* =[(pXaX*)ρρ−1+1(pXaX)ρρ−1+1]ρ−1ρaM aNaM*aN* .

It is easy to verify that, given the inequality (5.46), a permanent increase in the terms of trade, px, causes an appreciation of the RER: ∂Q∂x<0. Intuitively, an improvement in the terms of trade means, grosso modo, an increase in the real income for the country. A greater income implies more consumption, therefore an increase in the relative price of nontradables to rebalance the market of this good.

Notice that, since we assume the relative price of exportable goods is the same for both periods, the increase in the terms of trade is also the same for both periods. This assumption causes the terms of trade variation to not affect the relative disposable income between the two periods, so that it does not have an impact on the current-account balance. The exchange rate appreciation occurs because the terms of trade alter the relation between the current-account balance and the real exchange rate. More specifically, improvement in the terms of trade causes an increase in the trade balance for a given RER. Therefore, to maintain the trade balance and, consequently, a constant current account, there should be an appreciation of the RER.

Temporary changes in the terms of trade would, therefore, have an additional impact on the equilibrium current-account level. An improvement in the terms of trade represents an increase in domestic purchasing power. If the improvement is temporary, the effect on the current account is equivalent to a positive and temporary income shock (see Section 4.2): it causes an increase in the current-account balance. Greater current-account balances are associated with a more depreciated exchange, in this way mitigating the appreciation resulting from the direct impact on relative prices captured by Eq. (5.47) (Box 5.2).

Box 5.2

Empirical Studies on Equilibrium Real Exchange Rates

There is extensive and evolving empirical literature on the estimation of equilibrium exchange rates (EERs), which has generated several new creative acronyms. Among the different empirical approaches, there are CHEERs (capital enhanced EERs), ITMEERs (intermediate term model based EERs), BEERs (behavioral EERs), FEERS (fundamental EERs), DEERs (desired EERs), APEERs (theoretical permanent EERs), and PEERs (permanent EERs), whose description can be found in MacDonald (2000) and Driver and Westaway (2005). The models differ basically on the exchange rate definition they use, the time frame they envisage, and the way they model the dynamics.

CHEERs and ITMEERs focus on nominal exchange rate estimations. Both methods consider the financial dimension, which involves combining the purchasing power parity to the uncovered interest parity. ITMEERs add fundamentals to the estimation, such as the economic variables discussed in this chapter, to capture expected future movements in real exchange rates. BEER estimations focus on effective real exchange rates, using interest rate differentials and economic fundamentals as explanatory variables. Theoretically, they are based on the uncovered interest parity condition, where economic fundamentals are used to control for expectations of RER changes. All three of them, CHEERs, ITMEERs, and BEERs, are more closely related to short-term equilibrium.

FEERs and DEERs, on their turn, have a more medium-term perspective. They do not estimate equilibrium RER directly. They concentrate on estimating either complete macroeconomic models or simply current accounts, resulting in a RER consistent with medium term equilibria. APEERs and PEERs also focus on RER, but they are concerned with medium to long run equilibrium values.

2.2 The Domestic-Commitment Theory

The TOT theory is by far the one with the deepest roots in the literature, but it is not clear that TOT considerations are the whole story behind TAs, for at least two reasons. First, casual empiricism suggests that small countries (which have negligible influence on world prices) often agree to significant cuts in their trade barriers when they join a TA, an observation that is not easy to reconcile with the TOT theory.10 And second, as I mentioned above, the TOT theory implies that TAs should tend to increase export subsidies relative to their noncooperative levels, which is a counterfactual prediction. An alternative theory that can explain these observations is based on the idea that a TA can help a government tie its own hands vis-à-vis domestic actors.11

There are several models in the literature that fall within the broadly defined domestic-commitment theory. Some are of a purely economic nature, for example Staiger and Tabellini (1987), Tornell (1991), and Lapan (1988), and some are of a political-economy nature, in particular Maggi and Rodriguez-Clare (1998, 2007), Mitra (2002), Brou and Ruta (2009), Limão and Tovar (2011), and Liu and Ornelas (2012). Since the former type of domestic-commitment models was covered by Staiger’s (1995a) chapter, I will focus on the latter type, and in particular on the version due to Maggi and Rodriguez-Clare (1998, 2007).

The general idea proposed by Maggi and Rodriguez-Clare is that a TA can serve as a commitment device for a government to close the door to domestic lobbies. It has been argued by a number of scholars and commentators that this type of motivation was central to Mexico’s negotiations of the North American Free Trade Agreement (NAFTA). For example, Whalley (1998) argued that Mexican negotiators of NAFTA “were less concerned to secure an exchange of concessions between them and their negotiating partners, and were more concerned to make unilateral concessions to larger negotiating partners with whom they had little negotiating leverage…The idea was clearly to help lock in domestic policy reform.” Similarly, Bajona and Chu (2010) view China’s accession to WTO as a way to “…lock-in the agenda for fundamental domestic reforms, which has been difficult to implement by domestic measures alone.”

Notice however that, if one considers the typical models of lobbying that have been proposed in the literature, in particular those in the tradition of Grossman and Helpman’s (1994) “Protection for Sale,” it is not clear why a government would ever want to tie its own hands, since it derives positive rents from the political process.

Maggi and Rodriguez-Clare (1998) provide a theoretical justification for the domestic-commitment argument based on a simple dynamic model. The idea is that a government can derive rents from the interaction with lobbies in the short run, but in the long run this will distort the allocation of resources, and the government is not compensated for this long-run distortion. As a consequence, the government may be better off committing to free trade ex-ante, thereby shutting down the lobbying process.12

The basic points can be illustrated within the workhorse model of Section 2.1. Consider the same economic and political structure as in that model, but now suppose that H is a small country, while F is a large “rest of the world.” Also assume for simplicity that both sectors 1 and 2 are politically organized.

Consider the following timing: (0) the small-country government chooses whether to commit to free trade; (1) capital is allocated; and (2) given the capital allocation, trade policy and contributions are determined by Nash bargaining between the government and the lobbies (with σ denoting the government’s bargaining power). This timing captures the idea that capital is mobile in the long run but not in the short run.

Suppose first that the government does not commit to free trade. Let us proceed by backward induction and find the second-stage equilibrium payoffs given the capital allocation. For the Home country, let K denote the vector of capital allocations and τ the vector of trade policies. Also, let W(τ,K) and Π(τ,K) denote respectively the levels of general welfare and the aggregate returns to capital in sectors 1 and 2 as functions of trade policies and capital allocations. Given that the government and the lobbies engage in Nash bargaining over policies and contributions, the first step is to derive the status-quo (disagreement) payoffs. In the status quo, lobbies give no contributions and the government chooses the welfare-maximizing policy, which is free trade, hence the government’s status-quo payoff is aW(0,K), and the lobbies’ total status-quo payoff is Π(0,K). The next step is to write down the joint surplus of the government and the lobbies:

J(K)=maxτ[aW(τ,K)+Π(τ,K)]-[aW(0,K)+Π(0,K)].

The government walks away with a share σ of this joint surplus, therefore its payoff in the second stage is given by aW(0,K)+σJ(K) .

The next step is to derive the equilibrium allocation in the first stage, which I denote Kˆ. The key point is that, if σ<1, this will generically be different from the free trade allocation (Kˆ≠KFT), and hence inefficient, while K ˆ=KFT if σ=1. This is intuitive, because as long as lobbies have any bargaining power (σ<1), the presence of lobbying distorts the net returns to capital relative to free trade. If, on the other hand, lobbies have no bargaining power (σ=1), they will walk away from the bargain with no surplus, and hence the lobbying process does not affect the returns to capital net of contributions, so the equilibrium allocation is efficient. With this in mind, we can write the government’s equilibrium payoff in the no-commitment scenario as GNO=aW(0,Kˆ)+σJ(Kˆ).

Now suppose the government commits to free trade. In this case, expecting free trade, capital owners will make efficient allocation decisions: K=KFT, and hence the government’s payoff in this case is GCOMM=aW(0,KFT).

The government will commit to free trade if and only if GCOMM>GNO. Now observe that: (i) if σ=0, then GCOMM>GNO, because W(0,KFT )>W(0,Kˆ); and (ii) if σ=1, as I noted above we have Kˆ=KFT, and since J(KFT)>0 then GCOMM. We can then conclude that if σ is sufficiently low the government will commit to free trade, and if σ is sufficiently high it will not. Moreover, under some conditions GNO will be increasing in σ, in which case there will be a critical level of σ below which the government commits to free trade and above which it does not. Thus the model yields an interesting prediction: countries whose governments have a weaker bargaining position vis-à-vis domestic lobbies should be more likely to join a TA.

Another prediction generated by the model concerns the impact of the parameter a, the government’s valuation of welfare relative to contributions. Provided σ is sufficiently small, the value of commitment (V=G COMM-GNO) is non-monotonic in a: it starts negative, then it turns positive, and eventually it approaches zero as a→∞.13 This in turn implies that, if there is a small cost of joining the agreement, the government will choose to join if a falls in some intermediate range.

Importantly, note that if export interests are organized the noncooperative equilibrium will entail export subsidies, so in Maggi and Rodriguez-Clare (1998) the government may want to commit to the elimination of export subsidies. Thus the model suggests a possible solution to the “export subsidy puzzle” highlighted above in the context of the TOT theory: if TAs are motivated by domestic-commitment issues, they will reduce export subsidies relative to their noncooperative levels.

Next I make a point that will be useful to keep in mind when I focus on the implications of incomplete contracting for TAs (Section 3). Recall that in Maggi and Rodriguez-Clare (1998) the inefficiency in the noncooperative equilibrium stems from the government’s lack of commitment vis-à-vis domestic agents, and the core of the problem is that the government does not get compensated for the long-run distortions from trade protection. But note that the same problem can be viewed also as a problem of incomplete contracting between the government and domestic agents: if the government could sign a long-term contract with all the future beneficiaries of protection, in which it commits to future trade policies and gets compensated for them, the problem would disappear. Of course, if capital is mobile in the long run, this long-term contracting would have to involve all capital owners in the economy, not only those that are currently in the organized sectors, thus it seems reasonable to assume that such long-term contracting is not feasible.

Maggi and Rodriguez-Clare (2007) extends the previous model in four directions. First, it allows for two large countries; thus the model nests two motives for a TA: a domestic-commitment motive and a TOT motive. Second, governments can commit to arbitrary tariff levels (as opposed to free trade or nothing); moreover, they can do so through exact tariff commitments (a complete contract) or through tariff caps (an incomplete contract). Third, specific-factor owners can lobby ex-ante to influence the shape of the agreement, not only ex-post. And fourth, the model allows for different degrees of capital mobility across sectors.

The model considers the following dynamic scenario. The world is sitting at the noncooperative equilibrium—with its associated allocation distortions—when the opportunity to negotiate an agreement arrives.14 The agreement maximizes the joint surplus of governments and lobbies. After the agreement is signed, each investor gets a chance to move his or her capital with an (exogenous) probability z. The parameter z thus captures the degree of mobility of capital. After the reallocation of capital has taken place, tariffs are chosen in each country by the government and the lobby subject to the constraints set by the agreement. Of course, this ex-post lobbying process is relevant only if the agreement leaves some discretion, that is, if the TA takes the form of tariff ceilings.

The key results of the model are four. First, the extent of trade liberalization (the tariff cuts enacted by the TA) is increasing in the degree of capital mobility (z). Intuitively, if z is higher, current lobby members care less about future protection, and hence they are less resistant to tariff cuts. This in turn suggests a further prediction, beyond those highlighted above in the context of the small-country model: tariff cuts should be deeper in sectors where capital is more mobile. This prediction seems consistent with the anecdotal observation that in reality trade liberalization has been hard to come by in the agricultural sector, but it would be interesting to test this prediction in a more systematic way.

The second result concerns the impact of “politics” —captured inversely by the governments’ valuation of welfare (a)—on the extent of trade liberalization: tariff cuts are deeper when politics are more important, provided the domestic-commitment motive is strong enough (z sufficiently high). This result stands in interesting contrast with the prediction of the pure TOT model, where tariff cuts if anything tend to be less deep when a is lower: the reason is that a lower a implies higher noncooperative tariffs, hence a lower trade volume and a weaker TOT externality, and this calls for smaller tariff cuts. Also in Maggi and Rodriguez-Clare (2007), a lower a implies higher noncooperative tariffs, but this in turn implies a bigger allocation distortion, and hence bigger tariff cuts are called for. If z is high, this consideration dominates the previous one.

At a more fundamental level, the divergence in results highlighted above is a manifestation of a key difference between the domestic-commitment theory and the TOT theory. In the domestic-commitment theory, the motive for a TA is inherently political, since the TA is directly aimed at blunting domestic lobbying pressures, thus the TA is directly affected by political parameters such as the governments’ valuation of welfare; whereas in the TOT theory, the motive for a TA is inherently economic, and hence political forces affect a TA only indirectly through economic variables (e.g. outputs and trade volumes).

The third insight is that the presence of a domestic-commitment motive can explain why trade liberalization typically occurs in a gradual manner. In particular, the reduction in tariffs happens in two phases: first, there is an instantaneous drop in tariffs, which reflects the TOT motive for the TA, and subsequently there is a gradual tariff reduction, which reflects the domestic-commitment motive. Intuitively, the allocation distortions caused by protection are more severe in the long run than in the short run, and hence the domestic-commitment motive calls for bigger tariff reductions in the long run than in the short run. Furthermore, the speed of liberalization is increasing in z. The reason is that, if z is lower, the expected length of time for which capital owners are “stuck” in a sector is longer, so the lobby will insist on keeping a high protection level for a longer period of time.

Finally, Maggi and Rodriguez-Clare (2007) show that tariff ceilings are preferred to exact tariff commitments. The intuition is in two steps. First, if one focuses on complete TAs, the optimal exact tariff commitments in general are positive, though lower than the noncooperative levels, and hence induce allocation distortions. Second, consider replacing an optimal exact tariff commitment with a tariff ceiling at the same height: the former shuts down ex-post lobbying and contributions, while the latter leaves some discretion (governments have the option of setting tariffs below the ceilings) and hence induces ex-post lobbying and contributions; the latter is preferable because the anticipation of ex-post contributions reduces the expected net returns to capital in organized sectors, and hence mitigates the investment distortion. I will come back to the topic of tariff ceilings and the incompleteness of TAs in Section 3, where I focus on the design of TAs, but here I note that Maggi and Rodriguez-Clare’s model can explain why TAs are incomplete contracts without relying on the presence of contracting frictions between governments (although, as I highlighted above, contracting frictions between a government and its domestic actors are key).

Next I briefly discuss other papers that have highlighted domestic-commitment motives for TAs in the presence of lobbying. Mitra (2002) shows that a similar domestic-commitment motive as in Maggi and Rodriguez-Clare (1998) arises also in a setting where there is no long-run distortion in the capital allocation, but there is a resource cost of lobby formation: in this case, if the government does not commit to free trade, the long-run inefficiency generated by the prospect of trade protection (that the government does not get compensated for) is given by the cost of lobby formation. More broadly, Mitra’s paper suggests that there may be a domestic-commitment motive for a TA any time the prospect of trade protection leads to a long-run misallocation of resources, whether it is in the form of misallocation of resources between productive activities or waste of resources in unproductive activities.15 Brou and Ruta (2009) extend Maggi and Rodriguez-Clare’s (1998) model by allowing governments to use trade policies and domestic subsidies, and argue that the domestic-commitment theory of TAs can provide a rationale for the WTO’s restrictions on the use of production subsidies.

Limão and Tovar (2011) propose a different version of the domestic-commitment argument for TAs. They consider a setting in which a small-country government bargains with a domestic lobby over two policy instruments, a tariff and a non-tariff barrier, where the latter is the less efficient redistributive instrument. In this setting they show that the government may benefit from committing to a tariff reduction because this may improve its bargaining position, and this benefit may outweigh the cost of constraining the more efficient redistributive tool. Finally, Liu and Ornelas (2012) argue that a TA can serve as a commitment device for the purpose of stabilizing a democratic regime. The key idea of this paper is that an incumbent government may value a TA because it leads to the destruction of rents, which in turn reduces the likelihood of a coup by rent-seeking autocratic groups, thereby helping consolidate unstable democracies.16

I conclude this section by mentioning another model where a government’s lack of commitment vis-à-vis domestic agents has important implications for TAs. McLaren (1997) considers a two-period Ricardian model where a small country (S) negotiates a TA with a large country (L). In the first period, domestic agents commit their resources to a sector; in the second period, the governments negotiate over a tariff and a transfer through Nash bargaining. Given the resource allocation, the equilibrium TA involves free trade and a transfer from S to L. Ex-ante, anticipating free trade, agents commit resources to the sector where S has a comparative advantage. But this leads L to choose a higher tariff in the Nash equilibrium, which in turn worsens the outside option of country S in the trade negotiation. McLaren shows that this adverse effect of the anticipation of a TA on the welfare of the small country may outweigh the standard gains from trade, so this country may be better off by committing ex-ante not to sign a TA.

McLaren’s point relates in an interesting way to the domestic-commitment theory of TAs. In McLaren’s model, the TA can be interpreted as a short-term contract, because it occurs after investment decisions are made. But if the TA were a long-term contract, in the sense of occurring before investment decisions are made, then the hold-up problem highlighted by McLaren would not arise. Thus McLaren’s model suggests that TAs can help only if they are effective long-run commitments (consistently with the domestic-commitment theory), while they can have perverse effects if they are only short-term commitments.17

3.2.2 Offshoring: Bilateral Bargaining Over Prices

In the terms-of-trade approach, prices are determined in world markets, however in a sequence of papers Antras and Staiger (2012a,b) consider the case of offshoring where prices between upstream and downstream firms often involve bilateral bargaining (as well as a classic hold-up problem since the upstream supplier must customize the input for consumers). Thus, they consider a model of competition where international prices are no longer the result of market-clearing conditions, but rather a function of bargaining. They show that, in such an environment, there exist two international externalities: both the standard terms-of-trade externality and a trade volume externality (where trade volume also impacts the severity of the hold-up problem). In addition, Antras and Staiger show that, with bilateral bargaining over prices, a country's domestic policies will also be distorted in the Nash equilibrium and thus deeper integration will be required. Hence, Antras and Staiger's results suggest that changes in the international organization of production and market structure (shifting from prices being determined by market clearing to prices being determined by bilateral bargaining) can also influence the desirability of a deep vs shallow integration approach.

Indeed, the empirical literature has shown a complementarity between deep provisions in PTAs and offshoring. Specifically, Orefice and Rocha (2014) find that a larger share of parts and components between two countries relative to their total trade increases the probability that the two countries will sign a PTA covering deep provisions. This finding is consistent with the view that offshoring creates new forms of cross-border externalities that are not adequately addressed within the shallow approach of the WTO to NTMs and require deeper provisions that may more easily be negotiated in the narrower setting of preferential agreements.

Abstract

The exchange rate and terms of trade are two variables that are intertwined and quite often are used as a proxy for one another. While under some circumstances the interchangeability may be appropriate, that is not always the case. An exchange rate measures the price of one currency in terms of another. In turn, the terms of trade measure how many units of the foreign goods can one unit of the domestic good acquire. If the ratio of the Consumer Price Index (CPIs) in local currencies remains unchanged, the terms of trade and exchange rates will move in the same proportion, that is, the precise conditions under which the nominal exchange rate and the terms of trade are equivalent and thus interchangeable. But there is no reason to expect the ratio of the CPI’s to be constant, in which case the nominal exchange rate and real exchange rates will no longer be interchangeable or equivalent. If as we believe inflation is a monetary phenomenon, we need to introduce money into the framework that we have been developing. The determinants of the underlying inflation rate will drive the nominal exchange rate, the price of one currency in terms of another, while the real variables will determine the terms of trade.

5.3.2 Examples of Sell/Buy-Back

We use the same terms of trade given in Table 5.1 in section 5.2.2 but this time the trade is a sell/buy-back.7 In a sell/buy-back we require the forward price on termination, and the difference between the spot and forward price incorporates the effects of repo interest. It is important to note that this forward price has nothing to with the actual market price of the collateral at the time of forward trade. It is simply a way of allowing for the repo interest that is the key factor in the trade. Thus in sell/buy-back the repo rate is not explicit (although it is the key consideration in the trade) rather, it is implicit in the forward price.

In this example, one counterparty sells $10 million nominal of the US Treasury 3.625% 2019 at the spot price of 101.78, this being the market price of the bond at the time. The consideration for this trade is the market value of the stock, which is $10,209,146 as before. Repo interest is calculated on this amount at the rate of 6.25% for one week, and from this the termination proceeds are calculated. The termination proceeds are divided by the nominal amount of stock to obtain the forward dirty price of the bond on the termination date. For various reasons, the main one being that settlement systems deal in clean prices, we require the forward clean price, which is obtained by subtracting from the forward dirty price the accrued interest on the bond on the termination date. At the start of the trade the 3.625% 2019 had 32 days' accrued interest, therefore on termination this figure will be 32 + 7 or 39 days.

Bloomberg users access a different screen for sell/buy-backs, which is BSR. This is shown in Figure 5.7. Entering in the terms of the trade, we see from Figure 5.7 that the forward price is 101.7173. However, the fundamental nature of this transaction is evident from the bottom part of the screen: the settlement amount (“wired amount”), repo interest and termination amount are identical for the classic repo trade described earlier. This is not surprising; the sell/buy-back is a loan of $10,209 million for one week at an interest rate of 0.25%. The mechanics of the trade do not differ on this key point.

Screen BSR on Bloomberg has a second page, which is shown at Figure 5.8. This screen summarises the cash proceeds of the trade at start and termination. Note how the repo interest is termed “funding cost”. This is because the trade is deemed to have been entered into by a bond trader who is funding his book. This will be considered later, but we can see from the screen details that during the one week of the trade the bond position has accrued interest of $6,895. This compares unfavourably with the repo funding cost of $496.

If there is a coupon payment during a sell/buy-back trade and it is not paid over to the seller until termination, a compensating amount is also payable on the coupon amount, usually at the trade's repo rate. When calculating the forward price on a sell/buy-back where a coupon will be paid during the trade, we must subtract the coupon amount from the forward price. Note also that sell/buy-backs are not possible on an open basis, as no forward price can be calculated unless a termination date is known.

Example 5.2

Sell/Buy-Back Transaction

Consider the same terms as Example 5.1 above, but in this case as a sell/buy-back transaction. We require the forward bond price, and this is calculated by converting the termination money.

EUR 50,007,291EUR48,510,705×100=103.086

Example 5.1

Classic Repo

On 15 September 2009, a corporate wishes to invest EUR 50 million against German government bonds for 7 days. The collateral is the 3½% bunds due in July 2019. The repo rate is agreed at 0.75%. The bund price is 101.93 clean, which together with 1.141 accrued interest (119 days) gives a dirty price of 103.071.

The borrower of cash will need to determine the face value of bunds required at the current market price which will equate to EUR 50 million. This is shown below.

103.071100.0000=50,000,000X

The nominal value of bunds required (X) is 48,510,205.

The trade details are summarised below.

Note that the sale and repurchase prices are the same.

The accrued interest at the time of termination is subtracted from this price to obtain a forward clean price, as shown below.

103.086-1.208[126days]=101.878

The trade details are summarised below.

Note that the sale and repurchase prices are now different.

Are the Terms of Trade Constant?

Using worldwide data, we calculated the terms of trade or relative price changes as the local inflation rate less the local exchange rate depreciation against the US dollar, as well as the US inflation rate. A positive number means an improvement in the foreign economy’s terms of trade relative to the United States. That is, it takes more US goods to acquire one unit of the foreign good. A negative number means an improvement in the US terms of trade or a deterioration of the foreign economy’s terms of trade.

We applied the same methodology as before. We ranked the terms of trade changes for each year, constructed 189 series and split them into quartiles. We then calculated the average terms of trade changes for the second and third quartile. The results are reported in Fig. 2.11. The data shows that for most of the turning points, peaks and trough for the two series coincide.

One interpretation of these results is that the series identify the terms of trade changes. The fact that second quartile series is consistently higher than the third quartile has not escaped us. This result is not unrelated to the fact that the dollar inflation for the third quartile (Fig. 2.9) is lower than that of the third quartile. One possible explanation is measurement errors. If that is the case, then when the measurement errors are corrected, we would observe second and third quartile series converge to each other. And that will bring it all together. The relative price changes or terms of trade impact the different countries’ CPI differently. This suggests that these differences between the inflation rate series may be capturing the terms of trade changes. Once these relative prices are accounted for, the Law of One Price holds.

2.1 Competitive General-Equilibrium Model of Trade Agreements

We begin with the standard perfectly competitive general-equilibrium model of trade agreements. This model provides a general framework in which to understand the basic terms-of-trade-driven Prisoners’ Dilemma problem that a trade agreement may solve.

2.1.2 Prisoners’ Dilemma

We show next that the general-equilibrium model generates a terms-of-trade-driven Prisoners’ Dilemma problem between governments. To begin, let us consider a simultaneous-move game in which governments select import tariffs. Assuming that a unique, interior Nash equilibrium exists, we represent the non-cooperative or Nash tariffs as a pair, (τN, τ*N), satisfying the following first-order conditions:h

(6)dW(p,p~w)dτ=Wpdpdτ+Wp~w∂p~w∂τ=0dW*(p*,p~w)dτ* =Wp**dp* dτ*+Wp~w* ∂p~w∂τ*=0.

The first condition in (6) defines the “optimal tariff” or the best-response tariff for the home government, while the second condition defines the analogous tariff for the foreign government.i Using (4) and (5), we may immediately observe that Wp < 0 when the home government selects its optimal tariff. Intuitively, the home government would welcome the lower local price and corresponding greater trade volume that a tariff reduction would induce; yet, the home government refrains from unilaterally lowering its tariff from the optimal level, since a lower tariff would worsen its terms of trade. Similarly, for the foreign government, (4) and (5) imply that Wp**>0 at the optimal tariff, where a higher value for p* would result from a lower foreign tariff.

A trade agreement is an agreement between governments. To understand the rationale for a trade agreement, we thus consider whether a trade agreement could generate greater government welfare than governments enjoy under non-cooperative tariff setting (ie, in the Nash equilibrium). We are thus motivated to consider Pareto efficient tariff pairs, where efficiency is measured relative to government welfare. An efficient pair of tariffs is defined by a tangency condition for government indifference curves:

(7)dτ dτ*|dW=0=dτd τ*|dW*=0.

This tangency condition that defines an efficient pair of tariffs can be rewritten as

(8)[τWp+Wp~w]∂p~w∂τ*Wpdpdτ+W p~w∂p~w∂τ =Wp**dp* dτ*+Wp~w* ∂p~w∂τ*[ 1τ*Wp**+W p~w*]∂p~ w∂τ.

Notice that, in assuming that a trade agreement may deliver an efficient tariff pair, we are putting enforcement issues to the side for now.

Under the traditional approach, the optimal import tariff for each government is positive, and so τN > 1 and τ*N > 1. This finding dates back to Torrens (1844) and Mill (1844) and was formalized by Johnson (1953-1954). It implies that free trade is not the optimal unilateral tariff for a government that maximizes national economic welfare and presides over a large country. As Mayer (1981) showed, the efficiency frontier under the traditional approach is defined by the locus τ = 1/τ*. This tariff locus ensures that local prices are equalized across countries (ie, p = p*) and includes global free trade (τ = τ* = 1) as a special case. As we raise the home-country tariff and lower the foreign-country tariff while moving along the locus of efficient tariffs, the home (foreign)-country experiences a terms of trade gain (loss). Hence, the world price and thus the distribution of income across countries varies along the efficiency frontier.

The traditional approach thus indicates that governments of large countries face a Prisoners’ Dilemma problem. The Nash tariffs are too high, and governments could achieve a Pareto gain by forming an agreement in which tariffs are reduced in an appropriate reciprocal manner. If governments are symmetric, then Nash and efficient tariffs lie along the 45-degree line. In this case, governments can achieve efficiency and both gain relative to the Nash equilibrium by moving to global free trade. As Johnson (1953-1954), Kennan and Riezman (1988), and Mayer (1981) argue, however, if countries are sufficiently asymmetric, then a large country may prefer the Nash equilibrium to global free trade. Thus, reciprocal tariff reductions that lead to an efficient outcome do not always generate Pareto gains relative to the Nash equilibrium.

Adopting the more general political-economic approach, Bagwell and Staiger (1999, 2002) establish the following three findings. First, and as may be easily verified, the Nash equilibrium tariffs defined by (6) do not satisfy (8) and are thus inefficient. This finding is not entirely surprising, since a higher tariff from one country imposes a negative international externality in the form of a terms-of-trade loss on the other country. The second finding is that, starting at the Nash equilibrium tariffs (τN, τ*N), governments can mutually gain from moving to a new pair of tariffs (τ, τ*) only if the new tariffs entail reciprocal trade liberalization: τ < τN and τ* < τ*N. A general form of reciprocity is thus necessary if governments are to achieve mutual gains from a trade agreement.

The second finding follows easily once it is established that a government experiences a strict welfare reduction along its best-response curve as its trading partner's tariff is increased. To establish this point, we focus on the home country and define its best-response function, τ = τR(τ*), as the solution to the first equation in (6). Following Bagwell and Staiger (1999, 2002), we may now use (6) to find that

(9)dW(p,p~w)dτ*|τ=τR(τ*)=[(Wpτ+Wp~w)∂p~w∂τ*]|τ=τR(τ*)=[(1−τλ)Wp~w∂p~w ∂τ*]|τ=τR( τ*)<0,

where λ≡∂p~w∂τ/dpdτ<0 by (4). To complete the argument, we suppose that a trade agreement generates mutual gains and specifies a tariff pair (τ, τ*) for which τ* > τ*N. Starting at this tariff pair, we may reposition the home tariff to the home best-response level, τR(τ*), and then reduce the foreign tariff from τ* to τ*N while adjusting the home tariff along the home best-response curve. It then follows from (9) that the home government experiences strictly higher welfare at the Nash tariffs than at the tariff pair specified by the agreement, which contradicts the supposition that the agreement generate mutual gains. A similar argument applies when the trade agreement specifies a pair (τ, τ*) where τ > τN.

The third finding concerns the reason that the Nash tariffs are inefficient. To identify the source of the problem, Bagwell and Staiger (1999, 2002) define politically optimal tariffs as the tariff pair, (τPO, τ*PO), that satisfies

(10)Wp=0=Wp**.

We may understand the politically optimal tariffs to be the tariffs that governments would choose if, hypothetically, they were not motivated by the terms-of-trade implications of their tariff selections (ie, if, hypothetically, they acted as if Wp~w=0=W p~w*). The third finding, which follows easily from (8) and (10), is that the politically optimal tariffs are efficient. Bagwell and Staiger (1999, 2002) interpret this finding as establishing that the terms-of-trade externality is the sole rationale for a trade agreement, even when governments have political-economic preferences. They note further that the politically optimal tariffs correspond to global free trade when governments maximize national economic welfare.

The three findings are captured in Fig. 1 (adopted from Bagwell and Staiger, 1999). As this figure illustrates, Nash tariffs are inefficient and too high. Further, reciprocal tariff liberalization (ie, τ < τN and τ* < τ*N) is necessary but not sufficient for mutual gains for governments relative to the Nash equilibrium. Finally, politically optimal tariffs are efficient. As depicted, when the home and foreign countries are sufficiently symmetric, the politically optimal tariffs reside on the contract curve (ie, they are efficient and generate greater-than-Nash welfares for both governments). The politically optimal tariffs may fall outside the contract curve, though, if countries are sufficiently asymmetric.

Fig. 1. The problem for a trade agreement to solve.