Trade Openness and Volatility



(Newbery and Stiglitz 1984). The second hypothesis is that trade affects aggregate volatility
by changing the comovement between sectors. For example, when a sector is very open, it
may depend more on global shocks to the industry, and less on the domestic cycle (Kraay
and Ventura 2001). This channel has not, to our knowledge, been investigated empirically
in the literature. The third hypothesis is that trade changes the pattern of specialization.
For instance, if trade leads to a less diversified production structure, aggregate volatility
will increase, and vice versa.

The main results can be summarized as follows. First, trade openness increases volatility
at the industry level. Second, more trade in a sector results in a lower correlation between
growth in that sector and aggregate growth, an effect which leads to a reduction in aggregate
volatility, all else equal. Third, trade is associated with greater specialization, which works
as a channel for creating increased volatility.
3 The results are remarkably robust for all
three channels, over different sized panels, and to the inclusion of a plethora of fixed effects,
additional controls, and the use of instrumental variables in the case of the specialization
estimates. Indeed, for all three channels, we find that simultaneity is not a major problem.

Having estimated the three effects individually, we would like to establish whether these
have an appreciable impact on aggregate volatility. It could be, for instance, that a rise
in sector-specific volatility due to trade has a completely negligible impact on aggregate
volatility, because on average countries are well diversified across sectors. Thus, we use
our point estimates to calculate how important the three effects are quantitatively when it
comes to their impact on aggregate volatility. It turns out that an increase in sector-level
volatility due to moving from the 25
th to the 75th percentile in the distribution of trade
openness — equivalent to a movement in the trade-to-output ratio from 40 to 80 percent —
raises aggregate volatility by about 10.2% of the average aggregate variance observed in the
data, all else held equal. The reduction in comovement due to increased trade leads to a
fall
in aggregate volatility roughly equivalent to 3.9% of its average. Increased specialization in
turn implies an increase in aggregate variance of 12.8%. Adding up the three effects, our
estimates imply that moving from the 25
th to the 75th percentile in trade openness raises
aggregate volatility by about 19% of the average aggregate variance observed in the data.

We find that the impact of openness on volatility varies a great deal depending on
country characteristics, however. For instance, we estimate that an identical change in
trade openness raises aggregate volatility five times more in the average developing country
compared to the average developed country. Lastly, we estimate how the impact of trade
changes across decades. It turns out that all three channels, as well as the overall effect,
3 An important caveat is in order when interpreting our results. In this paper, we measure trade openness
by actual trade in a sector, rather than by trade barriers.



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