ECONOMETRICS PG PRESENTATION

Does Trade Cause Growth?

By Jeffrey A. Frankel And David Romer

The American Economic Review (Vol. 89, No. 3, June 1999)

 GROUP 10
 Members:
 Oscar Chipoka, Nishantha Gnanappriya Atulugamage, Su Yee Mon, Zar Ni Tin, Swarnim
Shikha
Outline of the presentation

 Introduction
 Methodology
 Model
 Estimation technique
 Results
 Basic Result
 Interpretation
 Robustness check
 conclusion
 Introduction
 This paper provides an empirical study of the impact of international trade on GDP per capita
(income per person).
 However, as Elhanan Helpman (1993) observes, trade share of GDP may be endogenous since
countries whose incomes are high for reasons other than trade may trade more.
 Other studies like Fischer (1991) have used measures of countries’ trade policies as an IV for the
trade share but these policies are likely to directly affect income and hence can’t be used as valid IV.
 This paper hence uses countries’ geographical characteristics like proximity and country size (based
on the gravity model of trade) as an alternative IV for trade share since geographical variables are
not a consequence of income or government trade policy and they can only affect income through
trade.
 The paper established that trade has a quantitatively large and robust, though only moderately
statistically significant, positive effect on trade
methodology

  Model


 Where:
 = real income per person
 = International Trade
 = Population of a country measured as its labour force
 = Area
Proximity & country size are negatively correlated, hence they controlled for both trade and
country size in the income equation to avoid the country size from being negatively correlated
with the error term
First stage equation: Bilateral Trade Equation (IV for Trade)

  ) = + + + + + + + + + + + + +
Where:
   = bilateral trade between countries i and j (measured as X + M)
 = Distance between countries i and j
 = population of countries i and j respectively
 = Areas of countries i and j respectively
 = if countries i and j share a common border
 =if countries i and j respectively are landlocked

 Dummy variables for landlocked countries and whether countries share a common border
are included because they have an important effect on trade
 Also include interaction terms of all the variables with the common-border dummy
because countries trade more with their neighbours and we need to identify geographic
influences in overall trade
First stage regression: result- geographical variables are major determinants of bilateral
trade
Implications for Aggregate Trade: geographical factors significantly account for
variation in countries’ overall trade
Estimation technique

 The authors used both the IV & OLS as estimation techniques

 Estimating Equation (1) by OLS will yield biased and inconsistent
estimates as there is simultaneity bias in the model.
 Therefore, the authors propose a powerful instrumental variable (IV)
approach to identify the effect of trade on income.
 As shown in Equation (2), they employed a set of geographical variables
(such as distance, landlockedness, common border etc) as an instrument
for bilateral trade.
 The basic exclusion restriction assumption is that these geographical
variables will affect income only through trade which is plausible.
Basic Result : From the income equation (eqn. 1)
Interpretation
 Columns 1 & 2 has sample size of 150 countries while the sample size for columns 3 & 4
is 98 countries
 OLS estimate under column 1 shows a statistically and economically significant
relationship between trade and income: a 1 percentage-point increase in the international
trade share raises income per person by 0.85 percent
 There is also a positive relationship between country size and income per person:
increasing both population and area by 1 % increases income per person by 0.1 %.
 Column 2 shows that estimating the same equation using IV increases the coefficient on
trade sharply from 0.85 to 1.97: a one-percentage-point increase in the trade share
increases income per person by 1.97 percent. (OLS understates the effect of trade).
 Furthermore, moving from OLS to IV also raises the estimated effect of country size on
income per person from 0.1 % to 0.28 percent.
 Columns 3 & 4 for n=98 shows that the change in the sample size has no significant effect
on the OLS estimates of the coefficient of trade and country size but increases both their
IV estimates & s.e(s) considerably
Robustness checks
1. They exclude Singapore and Luxemburg because they are the major outliers
2. They include countries’ distance from the equator or alternatively a dummy for each
continent as an additional control variable
3. Exclude oil producing countries and countries with poorest data from the sample
4. Construct new IV by dropping geographic variables one at a time from the bilateral
trade equation (landlocked dummy, population, all interactions with a common border
dummy; using total population rather than labour force in measuring countries’ sizes
and in computing income per person, and excluding area from both equations)
Conclusion
 This paper investigates the causal effect of trade on income for a large sample of
countries.
 To identify the effect of trade on income they employed a set of geographic
variables as an IV for trade.
 The paper finds that trade has a large and statistically significant positive effect on
income.
 Therefore, international trade is an important determinant for raising the
standards of living and also causes economic growth
Observation and critique

 Overall, our opinion is that the paper is good.

However:
 The value of R-squared in Table 3 is between 9 and 11 percent and it accounts for a small
proportion of the variation in income due to trade. Hence we can say it is not a good fit of
the model
 From our perspective, trade agreements can be included as a dummy in the income
equation where countries with trade agreements will have a relatively higher impact on
growth than countries with no trade agreements
Thank You!!!