Trade Openness and Volatility

Trade Openness and Volatility *

International Monetary Fund

June 22, 2006

Abstract

This paper examines the mechanisms through which trade openness affects output
volatility using an industry-level panel dataset of manufacturing production and trade.
The main results are threefold. First, sectors more open to international trade are
more volatile. Second, trade leads to increased specialization. These two forces act
to increase aggregate volatility. Third, sectors which are more open to trade are less
correlated with the rest of the economy, an effect that acts to reduce overall volatility.
The point estimates indicate that each of the three effects has an appreciable impact on
aggregate volatility. Added together they imply that the overall effect of trade open-
ness is positive and economically significant. This impact also varies a great deal with
country characteristics. We estimate that the same increase in openness raises aggre-
gate volatility five times more in developing countries compared to developed ones.
Finally, we find that the marginal impact of openness on volatility roughly doubled in
the last thirty years, implying that trade exerts a larger influence on volatility over time.

JEL Classifications: F15, F40

Keywords: Trade, Output Volatility, Specialization, Comovement, Sector-Level Data

*We would like to thank Fernando Broner, Andre Faria, Jean Imbs, Ayhan Kose, Akito Matsumoto,
Enrique Mendoza, Eswar Prasad, Petia Topalova, Jaume Ventura, workshop and conference participants at
IMF, Centro Studi Luca d’Agliano/CEPR Conference on Trade, Industrialization and Development (Chi-
anti), CREI/World Bank/CEPR Conference on the Growth and Welfare Consequences of Macroeconomic
Volatility (Barcelona), NBER IFM and ITI meetings, IMF Research Conference on Trade, and especially
Romain Ranciere, for helpful suggestions. Priyanka Malhotra provided expert research assistance. The views
expressed in this paper are those of the authors and should not be attributed to the International Monetary
Fund, its Executive Board, or its management. Correspondence: International Monetary Fund, 700 19th
Street NW, Washington, DC, 20431, USA. E-mail: [email protected], [email protected].

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