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Working Paper No. 12-02

How Trade Restrictions Disperse: Policy Dynamics with Firm Selection
Soojae Moon
October 2012


In this paper, I explore the aggregate e ects of trade restrictions in a two-country, dynamic, stochastic, general equilibrium (DSGE) model with rm selection and variable adjustment of markup. As a response to trade collapse in the global crisis of 2008 and 2009, trade restrictions have risen in several countries. By analyzing the dynamics of an economic slump in the home economy first, and the subsequent introduction of trade restrictions in the foreign economy, I show that both economies are in a worse position than they were during the economic downturn. The follow-ups to the recession and trade restrictions are analyzed through the three mechanisms: a) variable markup as a new avenue of `toughness' of competition for producers (e.g. more competitive firms lower their markups.); b) firms' individual specifoc productivity cut-off , which induces their optimum export choice (e.g. an increase in the export productivity cut-off means exporting becomes more diffcult than before.); and c) the movement of international relative prices (e.g. real exchange rate and terms of trade).

JEL classification: F12, F41, F42, F44
Keywords: Trade Restrictions, Entry, Heterogeneity, Variable markup, Cut-off productivity, IRBC, Trade Policy