Academic journal article IUP Journal of Applied Economics

Trade and Convergence: A New Approach and New Evidence

Academic journal article IUP Journal of Applied Economics

Trade and Convergence: A New Approach and New Evidence

Article excerpt

Whether international trade has any effect on income convergence across countries remains an open question. The present paper addresses this question by employing a novel approach and a new model over the period 1960-2003. By splitting the sample into two subperiods, it is found that the impact of trade on convergence has changed over time. This finding explains the conflicting reports in the literature on the impact of trade on convergence.

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Introduction

The neoclassical growth model demonstrates that every economy has a steady-state level of per capita income toward which the economy gravitates, and then grows at a rate determined by certain exogenous factors. The prime representative of the neoclassical growth model is Solow (1956), which rests on several assumptions including homogenous labor, diminishing returns and perfect competition as well as exogenously-determined technology and savings rates. Although the Solow model pertains to a closed-economy, it has implications for the real world of open economies. In particular, if the determinants of the steady-state per capita incomes are similar for a sample of countries, a convergence of per capita incomes across these countries is expected. In this model, the main endogenous source of output growth is capital accumulation while the substitution possibility and diminishing returns force the economy to converge to the equilibrium capital and income level (Islam, 2003, p. 313).

The foregoing analysis implies that lower-income countries have the potential to accelerate their growth rates and catch-up with higher-income countries by implementing policies that strengthen the determinants of the steady-state per capita income. The present paper focuses on international trade as a potential determinant of income level and evaluates its impact on the speed of per capita income convergence across a sample of countries over two periods, 1960- 1980 and 1980-2003. The paper draws on the neoclassical growth model as well as the theoretical and empirical literature on international convergence of per capita incomes.

Previous Studies

Ben-David and Loewy (1998) demonstrate that in the neoclassical growth model, trade liberalization can shift the steady-state income to a higher level and even increase the growth rate. Given the fact that the low-income countries are more protectionist than the high-income countries, the Ben-David-Loewy model implies that a movement toward freer trade would lead to international income convergence. In several papers, Ben-David (1996 and 1998) empirically shows that trade liberalization has indeed narrowed the income gap across trading countries. In a series of papers Williamson (1996 and 1997) also demonstrated that trade liberalization has contributed to income convergence over a very long period. Another influential work showing the impact of trade liberalization on convergence is of Sachs and Warner (1995). International trade is generally viewed as a channel for transferring technology, knowledge, and intermediate goods that have a greater effect on lower-income countries, and thus serve as a potent force for convergence (Grossman and Helpman, 1991, pp. 166-167).

The convergence hypothesis has been challenged on both theoretical and empirical grounds. Quite significantly, a key assumption of the neoclassical growth model, constant returns to both labor and capital, has been questioned by the proponents of the endogenous growth models. In several papers, Romer (1986 and 1990) has argued that if we double the quantity of labor and capital, then we may double the output, but if the knowledge of using labor and capital also doubles, then the output will be more than doubled and the model will exhibit increasing returns to scale. Once the assumption of constant returns is replaced by increasing returns, we can no longer expect income convergence because an initial income difference can perpetuate or even widen over time. …

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