We analyze the interaction of financial development and trade in a small open economy. In a benchmark economy with full financial development, there is no misallocation. When financial development is imperfect, access to borrowing in local currency is expensive. This causes misallocation to arise among the most productive firms. Productive firms with small initial capital access the international credit market by paying a fixed cost. By borrowing in foreign currency, they scale up close to their benchmark size. Larger firms borrow from domestic credit markets and are smaller than their benchmark counterparts. More expensive borrowing hinders firms to pay the fixed cost to export. Therefore, lower financial development causes firms to be worse off during devaluations, relative to the benchmark.

While most OECD countries experienced declines in manufacturing value added relative to GDP over 1970-2001, they have experienced increases in manufacturing exports relative to GDP during the same period. Bergoeing et al. (2004) documented this "value added-exports puzzle" and predicted that vertical specialization can explain it. Using the 1995-2018 data for 22 OECD countries and 17 manufacturing industries, we empirically investigate whether vertical specialization, or global value chain (GVC) participation, is a factor significantly affecting the puzzle. Our regressions show that the puzzle is stronger for countries and industries with the greater GVC backward linkage, while it is weaker for countries and industries with the greater GVC forward linkage. We also find that the puzzle is weaker for countries and industries that focus more on the upstream stage. Thus Bergoeing et al. (2004) were right, but we must be careful that the two measures of vertical specialization, the backward and forward GVC linkages, have the opposite effects.

Abstract: We develop a structural framework to identify the sources of cross-state heterogeneity in response to U.S. tariff changes. We quantify the effects of unilaterally increasing U.S. tariffs by 25 percentage points across sectors. Welfare changes range from −0.8 percent in Oregon to 2.2 percent in Montana. States gain more when their sectoral comparative advantage covaries negatively with that of the aggregate U.S. Consequently, “preferred” changes in tariffs vary systematically across states, indicating the importance of transfers in aligning state preferences over trade policy. Foreign retaliation substantially reduces the gains across states, while perpetuating the cross-state variation.

Large trade imbalances are a notable feature of the global economy and are frequently used as motivation for tariff increases by proponents of protectionism. Despite their frequent linkage in politics and media, the role between trade deficits and trade wars has largely been ignored in the literature. To evaluate how these factors interact, we study optimal tariff setting in a model featuring bilateral and aggregate trade deficits. We find that a higher bilateral trade deficit with a trading partner implies a higher optimal tariff for the country with the deficit, regardless of the trading partner’s ability to retaliate. Moreover, we show that this effect can be large enough that a country with a large trade deficit can have higher welfare in a trade war compared to a cooperative free trade equilibrium.