Value of WTO Trade Agreements in a New Keynesian Model

IMF Working Papers, February 25, 2015

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Paper revisits the quantitative benefits of WTO trade agreements in a non-standard setup from the traditional trade policy point of view.
In a New Keynesian model, unilateral trade liberalization reduces welfare due to terms-of-trade deterioration, creating an incentive for a trade agreement.
For realistic parameter values, the value of an agreement that cuts tariffs by one percentage point is 0.5% to 2% of consumption, much larger than in trade models.
Key New Keynesian features driving results include imperfect competition and endogenous labor supply.

Unilateral trade liberalization can reduce welfare because of terms-of-trade deterioration.
A coordinated trade agreement that reduces tariffs can generate sizable welfare gains relative to unilateral liberalization.
Quantitative valuation: a tariff cut of one percentage point yields welfare gains equal to 0.5% to 2% of consumption for realistic parameter values.

Imperfect competition: Market power alters price responses to tariff changes, affecting domestic welfare.
Endogenous labor supply: Labor-leisure tradeoffs amplify the welfare effects of trade policy through labor allocation and consumption channels.
Terms-of-trade channel: Deterioration of the terms of trade under unilateral liberalization offsets gains from lower tariffs, explaining the incentive for agreements.

Trade agreements can be welfare-improving relative to unilateral liberalization because they mitigate terms-of-trade losses.
Evaluations of trade liberalization should account for New Keynesian features such as imperfect competition and endogenous labor supply to capture larger potential gains from agreements.