Working Paper Revision

Financial Development and Trade Liberalization

Abstract: We study the role of financial development on the aggregate and welfare implications of reducing international trade barriers on imports of physical capital and intermediate inputs. We document that financially underdeveloped economies feature a slower response of real GDP, consumption, and investment following trade liberalization episodes that improve access to imported production inputs. To quantify the role of financial development, we set up a quantitative general equilibrium model with heterogeneous firms subject to financial constraints and estimate it to match salient features from Colombian plant-level data. We find that the adjustment to a decline of import tariffs on physical capital and intermediate inputs is significantly slower in financially underdeveloped economies in line with the empirical evidence. These effects reduce the welfare gains from trade liberalization; low-income agents experience smaller wage gains, while exporters cannot fully take advantage of lower capital costs.

Keywords: financial development; trade liberalization; welfare;

JEL Classification: F1; F4;

https://doi.org/10.20955/wp.2020.038

Status: Published in International Economic Review

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2020-11

Number: 2020-038

Note: Publisher DOI: https://doi.org/10.1111/iere.12620

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