On the Robustness of Short Run Gains from Trade Reform

The long run gains from reductions in distortionary tariffs are robustly positive in neoclassical economies. In the short run, however, depending on the prevailing exchange rate and tax regimes, a combination of producer price deflation and nominal wage stickiness can cause trade liberalisation to be contractionary. Because trade liberalisation, taken alone, reduces the home prices of foreign goods, there is a substitution away from home produced goods and a real depreciation. Under the explicit and de facto fixed exchange rate regimes adopted by many developing countries this necessitates a contractionary producer price deflation. Under the floating exchange rate regimes of the larger industrialised economies, if lost tariff revenue is replaced via a consumption tax increase, contractionary producer price deflation can also occur. This paper examines the implications of these and other policy combinations for the short run gains from trade reform using a comparative static numerical model of a generic, two-sector, “almost small” open economy with asset markets and forward looking agents.