Financial Development and Trade Liberalization

Abstract

We study the role of financial development on the aggregate effects and welfare implications of reducing international trade barriers on production inputs such as physical capital and intermediates. We document that financially underdeveloped economies feature a slower response of real GDP, consumption, and investment following trade liberalization episodes that improve access to imported production inputs. We set up a quantitative general equilibrium model with heterogeneous firms subject to financial constraints and estimate it to match salient features from Colombian plant-level data. We find that the adjustment to a decline of import tariffs on physical capital and intermediate inputs is significantly slower in financially underdeveloped economies in line with the empirical evidence. Moreover, we find that financial development increases the welfare gains from trade liberalization; low-income agents benefit from higher wages while exporters benefit from a depreciated real exchange rate and lower capital costs.