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Trade Policy under Endogenous Credibility

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  • 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.

Suggested Citation

  • Charles Engel & Kenneth Kletzer, 1987. "Trade Policy under Endogenous Credibility," NBER Working Papers 2449, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:2449
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    References listed on IDEAS

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    1. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    2. Calvo, Guillermo A, 1986. "Temporary Stabilization: Predetermined Exchange Rates," Journal of Political Economy, University of Chicago Press, vol. 94(6), pages 1319-1329, December.
    3. Backus, David & Driffill, John, 1985. "Inflation and Reputation," American Economic Review, American Economic Association, vol. 75(3), pages 530-538, June.
    4. David Backus & John Driffill, 1985. "Rational Expectations and Policy Credibility Following a Change in Regime," Review of Economic Studies, Oxford University Press, vol. 52(2), pages 211-221.
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    Cited by:

    1. Feestra, R.C. & Lewis, T.R. & Mcmillan, J., 1989. "Designing Policies To Open Trade," Papers 349, California Davis - Institute of Governmental Affairs.
    2. Basu, Arnab K. & Chau, Nancy H., 1999. "Adverse selection, asymmetric information, and foreign investment policies," International Review of Economics & Finance, Elsevier, vol. 8(3), pages 239-252, September.
    3. Ibarra, Luis Alberto, 1995. "Credibility of trade policy reform and investment: the Mexican experience," Journal of Development Economics, Elsevier, vol. 47(1), pages 39-60, June.
    4. Buffie, Edward F., 1995. "Trade liberalization, credibility and self-fulfilling failures," Journal of International Economics, Elsevier, vol. 38(1-2), pages 51-73, February.
    5. Dani Rodrik, 1993. "Trade and Industrial Policy Reform in Developing Countries: A Review of Recent Theory and Evidence," NBER Working Papers 4417, National Bureau of Economic Research, Inc.

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