Optimal Trade Policy with Trade Imbalances

By Mostafa Beshkar (Indiana University at Bloomington) and Ali Shourideh (Carnegie Mellon University)

A salient feature of international trade is the presence of trade imbalances. How should governments conduct their trade policy under trade imbalances? In a forthcoming paper we ask if trade imbalances influence governments’ choices of trade policies under a standard dynamic trade model.[1] This analysis could shed light on the policy debates in recent years where a widening trade deficit has prompted calls for protectionist policies in the United States and other countries with major levels of trade deficit.


We use a dynamic economic model to study the potential impact of fluctuations in trade volumes and trade deficits on the unilaterally-optimal choice of trade and capital control policies—namely, policies that maximize a measure of welfare of the home country disregarding their effects on the rest of the world.

By using a dynamic framework in which international lending and borrowing—and hence trade imbalances—may occur endogenously, our analysis departs from most of the trade policy literature that focuses on static models with the assumption of balanced trade or an exogenously-given trade deficit.

Using a dynamic—as opposed to static—framework has several advantages for policy analysis. First, it allows researchers to study the relationship between economic fluctuations and trade policy. The vast literature on trade policy—which has concerned itself mostly with static impacts of trade policy—cannot properly address this relationship.

A second advantage of a dynamic framework for trade policy analysis is the ability that it affords researchers to study the potential interdependence between trade and capital control policies. This potential policy interdependence may have important implications for the design and benefits of trade agreements. For example, while trade agreements such as the WTO restrict trade policies, they leave exchange and capital controls to the discretion of the member governments. Therefore, following negotiated trade liberalizations, governments may have an incentive to use exchange and capital controls more actively to affect trade flows to their advantage. It is notable that shortly after its accession to the World Trade Organization, China was frequently accused of manipulating its exchange rate to affect the flow of goods and services.

The use of a dynamic framework is also advantageous for quantitative analysis of trade policy as it could match observed trade flows that involve substantial trade imbalances. The balanced-trade assumption in the previous literature poses a problem for quantitative analysis as it violates the observed trade data. The static trade literature has so far dealt with this problem in one of two ways. The first approach is to introduce aggregate trade imbalances as constant nominal transfers into the budget constraints. The second approach is to “purge” the data from imbalances, namely, conducting the analysis under the counterfactual in which trade is balanced.[2]  A dynamic approach, however, provides a more satisfactory solution by allowing trade imbalances to occur endogenously


A key determinant of optimal trade and capital control policy in a given period is the productivity of the home country relative to the rest of the world in that period. The time variation in these policies, however, depend critically on the set of policy instruments that are employed by the government.

An important case is one in which trade taxes are the only policy instruments at the government’s disposal—i.e., there are no capital control taxes. Under this scenario, there is significant variation in optimal trade policy over time.  In particular, in the absence of capital control taxes, the optimal level of import restriction and export promotion—namely, import taxes and export subsidies—is counter-cyclical.

The counter-cyclicality of import tariffs and export subsidies reflects the government’s desire to improve the country’s intertemporal terms of trade.  That is, individual households ignore their collective effect on the world interest rate and, thus, save and lend too much in booms and borrow too much in downturns, which negatively affects the interest rate for domestic households. To correct for this “inefficiency,” the government’s optimal policy response would be to decrease the price of consumption in high-productivity periods relative to low-productivity periods. This objective may be achieved by applying lower import tariffs together with higher export subsidies in low-productivity periods.

Figure 1 Panel A

Figure 1 Panel B

Figure 1 depicts the optimal level of import and export taxes that we calculate in our paper, for the United States for each year from 1995 to 2016. As can be seen in this figure, over this time period optimal tariffs vary between 27% and 33%, and export subsidies vary between zero and 6%. Nevertheless, if capital controls are used in lieu of export subsidies, the time-variation of import tariffs is virtually eliminated—with tariffs hovering around 25% for the entire period.

The gradual increase in trade protection in the first-half of the time period in Figure 1 reflects an optimizing government’s motivation to discourage borrowing by households from the rest of the world during this relatively fast growth period. Conversely, the gradual decline in the optimal level of protection after 2003 reflects the government’s desire to encourage domestic consumption in lieu of lending to the rest of the world.

Despite the significant time-variation in import taxes and export subsidies that is depicted in Figure 1, the total level of trade protection, measured by the product of import and export taxes, namely, (1+import tax)*(1+export tax), remains relatively constant (around 25%) for the entire time period. In other words, the desired relative price of domestic and imported goods may be implemented using a 25% import tariff alone. Nevertheless, to induce the desired interest rate—or, equivalently, the desired relative price of aggregate consumption across periods—both tax instruments are necessary. This observation suggests that the famous Lerner Symmetry Theorem should be interpreted cautiously in practice.

Remaining Questions

Given the insights we have discussed above, an interesting question that could be addressed in future research is whether capital controls could serve a useful purpose as a flexibility mechanism in trade agreements. Flexibility may be a desirable feature for trade agreements for at least two reasons. First, if political economy preferences are subject to shocks in the future governments will negotiate an agreement that includes a mechanism for policy flexibility such as the WTO Agreement on Safeguards.[3] Second, if trade agreements must be self-enforcing, flexibility in capital control policies could reduce the governments’ incentive to renege on the agreement at times when a surge in imports or a widening trade deficit increases temptations to leave an international agreement.[4]

The possibility of time variation in trade policy is also important in understanding the potential relationship between the state of the economy and optimal trade policy. This is particularly so in order to understand the pattern of optimal trade taxes over the business cycle and the potential relationship between the growth rate of the economy and the optimal conduct of trade policy.  Our model offers a tractable framework in which to explore these issues.


In conclusion, it is worth noting that although the magnitude of changes in optimal tariffs are significant, the quantitative analysis suggests that the gains from this variation are small. In particular, a constant tariff can achieve almost all of the gains from implementing the optimal policy. This finding also implies that under our framework, the negative externality of optimal capital control taxes on the rest of the world is very small.

These quantitative results, however, should be taken with a grain of salt as they hinge on various simplifying assumptions, including the assumption that labor is the only factor of production and no investment in physical capital takes place. Enriching the model by allowing for the possibility of physical capital formation could potentially magnify the welfare effects of capital control policies.


Bagwell, K., and R. Staiger, (1990); “A Theory of Managed Trade.American Economic Review, 80(4): 779-795.

Maggi, G., and R. Staiger (2011); “The Role of Dispute Settlement Procedures in International Trade Agreements.” The Quarterly Journal of Economics, 126, (1): 475-515.

Beshkar, M., and E. Bond, (2017); “Cap and Escape in Trade Agreements.” American Economic Journal – Microeconomics. 9(4): 171–202.

Beshkar, M., and A. Shourideh, (2020); “Optimal Trade Policy with Trade Imbalances.” Journal of Monetary Economics.

Ossa, R. (2016); “Quantitative Models of Commercial Policy.” Published in K. Bagwell and R. Staiger (eds) Handbook of Commercial Policy. Amsterdam, Elsevier.


[1] Beshkar and Shourideh (2020).

[2] See Ossa (2016).

[3] See Maggi and Staiger (2011), Beshkar (2010), and Beshkar and Bond (2017) among others.

[4] The logic here is similar to that of Bagwell and Staiger (1990).



Price, Product Quality, and Exporter Dynamics: Evidence from China

By Joel Rodrigue (Vanderbilt University) and Yong Tan (Nanjing University of Finance and Economics)

For the typical Chinese exporter, foreign sales grew exponentially after China’s entry to the WTO.  How was this so-called ‘economic miracle’ achieved in such a short span of time? Answering this question has been the focus of policymakers, government officials, and academic researchers across the globe.

Our recent paper adds to a rich literature studying the determinants of Chinese export growth.[1] In particular, we examine the impact that consumer loyalty has on the market strategies adopted by Chinese firms to successfully grow into high-value export markets.  Even if they were aided by falling trade costs, convincing foreign consumers to purchase Chinese goods for the first time is no small feat.  To clear this hurdle we argue that Chinese firms systematically chose to enter markets producing low quality products and setting low prices.

This doesn’t mean the stereotype that Chinese exports are broadly low price or low quality is accurate.  Rather, as foreign consumers adopted new Chinese goods, producers adjusted production to produce higher quality, higher price, higher-value varieties.  In this sense, the rapid Chinese export-driven economic growth has occurred alongside an observable rise in the nation’s firm-level climb up the value-chain.

Our approach builds on the static O-ring models of endogenous quality choice under monopolistic competition.[2]  We extend this setting to consider the dynamic pricing and product quality decisions by bridging this framework with models of habit persistence and demand accumulation.[3]  A key outcome from this marriage of ideas is that exporting firms will alter markups and product quality over time in order to grow sales rapidly during the initial years after entry and develop a large customer base.

The degree to which firms care about the future, however, depends on the firm’s long-run outlook in competitive export markets.  Small, unproductive firms are more likely to produce low quality products and yield little discount initially because they don’t expect to serve the same consumers more than once.  In contrast, the most efficient firms optimally aim to reach consumers by offering good value for their dollar: high quality products at a relatively low price.

To fix ideas we focus on the production of electric kettles, a small electronic appliance, typical of much of China’s export growth.  In Figure 1 we depict the evolution of export prices, product quality and export sales for a representative firm in a typical export market.  New Chinese exporters, despite producing low quality varieties, sell these goods one percent cheaper than established firms selling the same quality of electric kettle.  While this difference might sound small, it is worth at least 4 percent higher export sales in the firm’s first year – often the difference between breaking even or losing money when a firm enters new markets.

Over time the impacts are even larger.  While the export sales of a typical kettle producer grew by nearly 80 percent between 2001 and 2006, Chinese producers systematically added new features to their products: stainless steel casings, rapid heating systems, larger capacity, etc.  Adding these desirable product characteristics, however, is not free.  Rather, we document that over a five-year period typical input costs rose by twelve percent to incorporate higher quality attributes.

Not surprisingly product quality upgrading is likewise found to drive a large part of Chinese export growth; observed product improvements account for at least 17 percent of the aggregate growth in kettle exports over the same time period. As Chinese firms further entrenched themselves in foreign export markets, their profits rose accordingly: markups increased by nearly 2 percent over the same time period as Chinese firms exported kettles at higher and higher profit margins.

The consequences for trade policy are manifold.  In particular, price effects are likely to be muted in response to changes in trade policy.  While tariff declines are found to directly reduce the price consumers pay, product quality upgrading has an opposing effect.  Quality upgrading offsets price declines because high quality products are more expensive to produce, but also because it induces higher producer markups.

In contrast to the long march towards free and unfettered trade after WWII, recent tariff policy can broadly be characterized by unprecedented tariff increases in many countries.  Nowhere is this more evident than US trade policy vis-à-vis China where tariffs have increased sharply, but – surprisingly – prices have remained remarkably stable despite the rise in trade costs.[4]  Could this reflect changes in product characteristics and markups?  That remains unclear.  What is clear is that Chinese producers will react to tariff change on multiple fronts to maintain and grow their foothold in US export markets.  Ignoring the multi-dimensional responses of producers can potentially misrepresent the nature and impact that tariff policy has on firm behavior.


Amiti, Mary, Stephen J. Redding, and David Weinstein, (2018); “The Impact of the 2018 Trade War on U.S. Prices and Welfare.’’ NBER Working Paper No. 25672.

Fajgelbaum, Pablo, Pinelopi Goldberg, Patrick Kennedy, and Amit Khandelwal, (2019); “The Return to Protectionism.” NBER Working Paper No. 25638.

Gilchrist, Simon, Raphael Schoenle, Jae. W. Sim, and Egon Zakrajsek, (2017); “Inflation Dynamics During the Financial Crisis.” American Economic Review, 107(3): 785-823.

Kugler, Maurice and Eric Verhoogen, (2012); “Prices, Plant Size, and Product Quality.” Review of Economic Studies, 79(1): 307-339.

Piveteau, Paul, (2018); “An Empirical Dynamic Model of Trade with Consumer Accumulation.” Working Paper, Columbia University.

Rodrigue, Joel and Yong Tan, (2019); “Price, Product Quality, and Exporter Dynamics: Evidence from China.” International Economic Review, forthcoming.


[1] Rodrigue and Tan (2019).

[2] See Kugler and Verhoogen (2012).

[3] In our model, habit persistence is based on Gilchrist et al (2017), while demand accumulation is based on Piveteau (2018).

[4] See Amiti et al (2018) and Fajgelbaum et al (2019).

Welcome New Members May 2019

We would like to welcome the following new members to the InsTED Network

Prof Kathy Baylis (University of Illinois at Urbana-Champaign) Her research interests lie in the design of agricultural, conservation, and trade policy to promote ecosystem preservation and international food security.

Ms Casey Petroff (Harvard University).  Her research interests are in economic development and public policy, focusing on the development of public good provision relating to health care.

(When) Do Anti-poverty Programs Reduce Violence? India’s Rural Employment Guarantee and Maoist Conflict

Aditya Dasgupta (University of California, Merced), Kishore Gawande (University of Texas, Austin), and Devesh Kapur (Johns Hopkins University – SAIS)

More than half of all nations have experienced a violent civil conflict since 1960.[1] One of the best predictors of conflict outbreak in a country is a low level of economic development and whether it has experienced a civil conflict in the past, suggesting the existence of “conflict trap” in which poverty and violence reinforce one another over time. This begs the question: how do nations break out of the vicious cycle of poverty and violence?

Poverty encourages participation in armed civil conflict in at least two ways. First, it creates economic and political grievances among impoverished groups, providing fertile ground for rebel groups to draw support from those who feel neglected by the state. Second, a lack of employment opportunities and stable livelihoods reduces the opportunity costs of participating in violent conflict, making it easier for rebel groups to recruit fighters.

If poverty fuels violence, then anti-poverty programs ought to play an important role in pacifying violent civil conflict. A large and growing scholarly literature has examined this policy implication, coming to surprisingly mixed conclusions. One randomized study of Afghanistan’s largest development program finds that the program contributed to a modest reduction in violence.[2] Another important randomized study in Liberia found that a combination of cash payments and therapy produced a durable reduction of participation in crime and violence among at-risk young men.[3] Other studies, especially those that examine the roll-out of large-scale government programs and not pilot experiments, have found that foreign aid and development programs are sometimes associated with increases in violence.[4]

How do we reconcile the conflicting evidence, especially the disjuncture between micro-level randomized studies by researchers and the program evaluation literature? We argue that state capacity, or the bureaucratic capacity of a government to successfully implement programs, may play an important role in actuating the pacifying effects of anti-poverty programs. In conditions of low state capacity, program funds are unlikely to pass through to local populations and corruption may even reinforce local grievances with the state and provide opportunities for rebel financing. When local state capacity is strong, however, antipoverty programs have a better chance of actually reducing poverty, improving perceptions of the state, and dis-incentivizing participation in deadly conflict.

To examine this hypothesis, we empirically examine how the roll-out of India’s National Rural Employment Guarantee Scheme (NREGS), a large-scale anti-poverty program which guarantees every rural household in India up to 100 days of public works employment, affected the intensity of the Maoist conflict, a protracted conflict between a Maoist insurgency concentrated in eastern India and the Indian government. Because the roll-out of NREGS was staggered in three phases between 2006 and 2008, we can employ a difference in differences research design. If NREGS reduced violence, we should observe a reduction in violence in districts adopting the program relative to districts experiencing no change in their program adoption status. Moreover, if these pacifying effects depended on state capacity, we should observe that these effects are mainly concentrated in districts with a high level of state capacity, which varies quite substantially across regions and districts of India.

To measure the intensity of the Maoist conflict, we assemble a new panel dataset of violent incidents and deaths at the district level, drawing on the archives of local language newspapers, which ensures that we get adequate temporal and spatial coverage of a long-simmering conflict that occurs mainly in rural areas; existing datasets that draw exclusively on English language sources are heavily biased toward more recent conflict events and those that are close to urban areas. To measure district-level state capacity, we average the ranking of districts across four indicators of basic service provision according to the 2001 census based on the share of villages with: (1) a paved road; (2) a primary school; (3) a primary health center; and (4) an agricultural credit cooperative (the lowest tier of the Indian government’s agricultural credit network).

Using these data, we come to two main findings. First, overall the adoption of NREGS was associated with a large reduction violent incidents and deaths, especially over the long run. To provide a back-of-the-envelope calculation of the size of the pacifying effects, consider the total levels of violence observed in 2008: 619 violent incidents resulting in 751 deaths. According to our regression estimates, counter-factually without the adoption of NREGS across districts, levels of total violence would have been 1,440 violent incidents resulting in 2,030 deaths suggesting that the program eliminated roughly 821 potential violent incidents and 1,279 casualties across districts in that year.

Second, these effects were concentrated in districts with high levels of state capacity. Our analysis of heterogeneous effects suggests that the violence-reducing effects of NREGS were concentrated almost entirely in the top two quartiles of districts in terms of state capacity. In the districts in the bottom two quartiles of state capacity, the program had essentially no impact on violence at all.

What conclusions do we draw? First, NREGS has probably played an important role in the long-term pacification of the Maoist conflict in India. Second, one reason for the mixed evidence from the program evaluation literature on the impact of development programs on violence is that the pacifying effects of anti-poverty programs depend heavily on state capacity, which can vary considerably across and within countries. Indeed, other recent studies have come to similar conclusions – that development programs can reduce violence, but primarily in areas where the state possesses a monopoly of violence and has the capacity to carry out its developmental activities without rebel subversion.[5]

To reduce violence, therefore, policymakers need to encourage not only development through anti-poverty programs, but also the strengthening of bureaucratic and state capacity.


Beath, A., F. Christia, and R. Enikolopov, (2013); “Winning Hearts and Minds Through Development: Evidence from a Field Experiment in Afghanistan.” Paper presented at the 110th Annual Meeting of the American Political Science Association, August, Chicago.

Blattman, C., J.C. Jamison, and M. Sheridan, (2017); “Reducing Crime and Violence: Experimental Evidence from Cognitive Behavioral Therapy in Liberia.” American Economic Review 107(4): 1165-1206.

Blattman, C., and E. Miguel, (2010); “Civil war.” Journal of Economic Literature 48(1): 3-57.

Crost, B., J. Felter, and P. Johnston, (2014); “Aid Under Fire: Development Projects and Civil Conflict.” American Economic Review 104(6): 1833-56.

Sexton, R., (2016); “Aid as a Tool Against Insurgency: Evidence from Contested and Controlled Territory in Afghanistan.” American Political Science Review 110(4): 731-749.


[1] Blattman and Miguel (2010).

[2] Beath, Christia, and Enikolopov (2013).

[3] Blattman, Jamison, and Sheridan (2017).

[4] Crost, Felter, and Johnston (2014).

[5] Sexton (2016).


Welcome New Members June 2018

We would like to welcome the following new member of the InsTED network:

Prof Pol Antràs (Harvard University): His research interests are in International Economics and Applied Theory. His most recent work is focused on the analysis of global value chains and on the interplay between trade, inequality and costly redistribution.

Prof Prabhat Barnwal (Michigan State University): His research interests are in Development Economics, Environmental and Energy Economics, Public Finance and Health Economics.

Yang Liang (Syracuse University): His research interests are in International Trade, Labor Economics and Applied Microeconomics.

Prof Nina Pavcnik (Dartmouth College): Her research interests are in International Trade, Development and Industrial Organisation.

Welcome New Members May 2018

We would like to welcome the following new members of the InsTED network:

Dr Ama Baafra Abeberese (Wellesley College): Her research interests are in Development Economics with an emphasis on firm behavior in developing economies.

Dr Ritam Chaurey (Johns Hopkins School of Advanced International Studies): His research interests are in Development Economics, Finance and Development, Evaluation of Public Programs and Urban Economics.

Prof Sebastian Krautheim (University of Passau): His research interests are in International Trade and Foreign Direct Investment, Offshoring, Trade and NGO Activism and International Tax Competition.

Dr Rocco Macchiavello (London School of Economics): His research interests are in industrial zones and policy in emerging markets, markets and firms in weakly institutionalized environments, organized crime and international drug trafficking.

Dr Ariel Weinberger (University of Oklahoma): His research interests are in International Trade, Macroeconomics and Aggregate Productivity.

Mingzhi Xu (University of California Davis): His research interests are in International Economics, Development, Macroeconomics and Economy of China.