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Trade, Foreign Investment, and Industrial Policy for Developing Countries 4087

F-statistic from 3.06 using Frankel and Romer’s bilateral trade pairs to 11.66. This
gives them two and a half times the number of observations in the first stage relative
to Frankel and Romer. Consequently, the second stage relationship between their cho-
sen measure of openness and their dependent variable Y (the log of PPP GDP per capita
in 1985) is more robust. They also add a measure of institutional quality to the Z vec-
tor, which addresses the concern that trade is positively correlated with income or
growth because greater openness is correlated with better institutions. They instrument
institutional quality with language and settler mortality data, drawn from Hall and
Jones, and Acemoglu, Johnson, and Robinson. Nevertheless, any analysis which uses
geography as an instrument is still restricted to a pure cross section analysis, which
requires the researcher to find all possible covariates which could induce a spurious
correlation between OPENNESS and Y.
There are other aspects to Alcalá and Ciccone (2004) which suggest that the rela-
tionship between openness and income in a pure cross section is not very robust. Trade
openness is only significantly correlated with Y if the authors use a “real” measure
of openness, defined as the ratio of PPP trade to GDP. Nominal trade shares are not
significantly associated with GDP per capita, which leads Rodrik, Subramanian, and
Trebbi (2004) to suggest that Alcala and Ciccone’s results are driven by movements
in the price level, not by trade. It is difficult to be sure, however, since Rodrik,
Subramanian, and Trebbi do not use exactly the same specification as Alcala and
Ciccone.
Romalis (2007) suggests another clever instrument for a country’s OPENNESS:
tariffs imposed by a country’s trading partners. In particular, Romalis uses US most-
favored nation (MFN) tariffs as an instrument for developing country trade shares.
Using this instrument, he shows that the change in real per capita GDP is positively
and significantly affected by trade, and that the magnitude is economically important.
Using MFN tariffs is particularly clever, since these are unlikely to be influenced by
developing country behavior and are consequently exogenous. This is at the same time
a limitation of the approach: the instrument only varies over time, not across countries
since the United States must apply the same MFN tariffs to all its trading partners. The
results also could be interpreted to suggest that other country policies matter for devel-
oping country growth. What Romalis shows is that access for developing country
exports is beneficial for growth, but his research does not indicate whether opening
up import-competing sectors to competition through reductions in protection is also
beneficial for growth.
Two very recent studies which make an important contribution to resolving the
endogeneity of trade and growth are Feyrer (2009) and Donaldson (2009). Feyrer
(2009) suggests a solution to the problem faced by Frankel and Romer in using geogra-
phy as an instrument. To overcome the fact that their instrument did not vary over time,
which made it impossible to control for country fixed effects, Feyrer allows the