Specialization, Market Access and Medium-Term Growth

This paper estimates the impact of foreign sectoral demand and supply shocks on medium-term economic growth. Our empirical strategy is based on a first order approximation to a wide class of small open economy models that feature sector-level gravity in trade flows. The framework allows us to measure foreign shocks and characterize their impact on growth in terms of reduced-form elasticities. We use machine learning techniques to group 4-digit manufacturing sectors into a smaller number of clusters, and show that the cluster-level growth elasticities can be estimated using high-dimensional statistical techniques. We find clear evidence of heterogeneity in the growth elasticities of different foreign shocks. Foreign demand shocks in complex intermediate and capital goods have large growth impacts, and both supply and demand shocks in capital goods have particularly large impacts on growth for poor countries. Counterfactual exercises show that both comparative advantage and geography play a quantitatively large role in how foreign shocks affect economic growth.