Improving the Analysis of Trade Policy

Timothy J. Kehoe, Consultant

Pau S. Pujolàs

Jack Rossbach

January 2018 | Federal Reserve Bank of Minneapolis Economic Policy Paper 18-1

The standard model that economists use to analyze the impact of trade reforms systematically underpredicts changes in trade patterns. It not only underestimates overall trade magnitudes, but also fails to predict which industries experience the largest trade increases. This failure results from not accounting for rapid growth in post-liberalization trade of the products that these industries produce. This paper documents these weaknesses and demonstrates an alternative methodology. Our modified model performs better because it accounts for the rapid growth of trade in products that were traded in small quantities prior to the reduction of trade barriers. We offer a method for integrating this insight about least-traded products into the standard model and suggest that such models not only will produce more accurate predictions, but also will forecast larger welfare gains from trade liberalization.