Trade Openness and Volatility



1 Introduction

Macroeconomic volatility is considered an important determinant of a wide variety of eco-
nomic outcomes. Numerous studies identify its effects on long-run growth (Ramey and
Ramey 1995), welfare (Pallage and Robe 2003, Barlevy 2004), as well as inequality and
poverty (Gavin and Hausmann 1998, Laursen and Mahajan 2005). The question of what
are the main determinants of macroeconomic volatility has thus attracted a great deal of
attention in the literature. In particular, it has been argued that trade openness plays
a role (Rodrik 1997, ILO 2004). As world trade has experienced exponential growth in
recent decades, understanding the relationship between trade and volatility has become
increasingly important. Figure 1 shows a scatterplot of trade openness and the volatility
of GDP growth in the 1990s for a large sample of countries, after controlling for per capita
income. Differences in volatility are pronounced: countries in the 75
th percentile of the out-
put volatility distribution exhibit a standard deviation of growth some three times higher
than those in the 25
th percentile. At the same time, it appears that the correlation between
openness and volatility is positive in the data.
1

There is currently no consensus, either empirically or theoretically, on the nature of the
relationship between trade openness and macroeconomic volatility. In part, this is because
the mechanisms behind it are not well understood. For instance, does trade affect volatility
primarily by exposing industries to external shocks? Or because it changes the comovement
properties of the trading sectors with the rest of the economy? Or does trade affect volatility
through its impact on the diversification of production across sectors?
2 The main purpose
of this paper is to answer these questions by examining the relationship between trade
openness and volatility using an industry-level panel dataset on production and trade. The
use of industry-level data allows us to look into the individual channels through which trade
can affect aggregate volatility.

We begin by testing three hypotheses. The first is that trade openness affects the
volatility of individual sectors. For instance, has been suggested that in an economy open
to international trade, an industry is more vulnerable to world supply and demand shocks

1 A number of cross-country empirical studies analyze the relationship between trade openness and volatil-
ity. Easterly, Islam and Stiglitz (2001) and Kose, Prasad and Terrones (2003) find that openness increases
the volatility of GDP growth. Kose et al. (2003) and Bekaert, Harvey and Lundblad (2004) also find that
greater trade openness increases the volatility of consumption growth, suggesting that the increase in output
volatility due to trade is not fully insured away. Moreover, Rodrik (1998) provides evidence that higher
income and consumption volatility is strongly associated with exposure to external risk, proxied by the
interaction of overall trade openness and terms of trade volatility. Recent work by Bejan (2004) and Cavallo
(2005) finds that openness decreases output volatility.

2 Koren and Tenreyro (2006) emphasize that aggregate volatility can arise from volatility of individual
sectors, patterns of specialization, and the covariance properties of sectors with the aggregate shocks.



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