Endowment Versus Finance: A Wooden Barrel Theory of International Trade

Author/Editor:

Jiandong Ju ; Shang-Jin Wei

Publication Date:

June 1, 2005

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

This paper develops a theory of international trade in which financial development and factor endowments jointly determine comparative advantage. We apply the financial contract model of Holmstrom and Tirole (1998) to the Heckscher-Ohlin-Samuelson (HOS) model in which firms' dependence on external finance is endogenous, and the demand for external finance is constrained by financial development. The theory nests HOS model as a special case. A key result that emerges is what we call the law of a wooden barrel: if the external finance constraint is binding, then further financial development will increase the output of the industry more dependent on external finance, and decrease the output of the other industry. It is shown that financial development makes both labor and unemployed capital better off, but incumbent capital worse off. Therefore, financial development depends on the relative strength of political forces among labor, unemployed capital owners, and incumbent capital owners. If only the capital constraint is binding, on the other hand, the standard HOS predictions will apply.

Series:

Working Paper No. 2005/123

Subject:

Capital markets Commodity markets Financial sector development Labor Liquidity

English

Publication Date:

June 1, 2005

ISBN/ISSN:

9781451861426/1018-5941

Stock No:

WPIEA2005123

Pages:

29

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