Asset markets, stochastic policy and international trade

The present study examines the role of financial markets for trade policy under conditions of uncertainty. It builds upon and extends an earlier work by Stockman and Dellas. Using a two country, two good stochastic general equilibrium model where both countries impose a combination of export and import tariffs and the agents trade in financial contracts to insure against policy risk, with the provision of spot trading in consumption goods, it is shown that: (i) the structure of commercial policy (i.e. import or export tariffs) matters, so that Lerner's symmetry theorem does not extend to a stochastic framework with asset markets; (ii) the Stockman-Dellas conclusions are sensitive to the choice of tariffs; (iii) in general, it is optimal to use both export and import tariffs in such a framework;The assumption of exogenous tariffs is relaxed next by making endowments random and by assuming tariffs are chosen optimally. The values of optimal policies are compared across states within any regime as well as across alternative policy regimes. The simulation results indicate that the expected welfare when both export and import tariffs are used is at least as high as that when only import tariffs are used. However, if commercial policy is restricted to import tariffs, the introduction of asset markets can be welfare-deteriorating, even though there remains potential gains from engaging in inter-state trade. Finally, the potential time consistency issues inherent in such a framework are addressed. The financial structure is found to play a crucial role in determining the time consistent policy ex post.