Output Volatility and Openness to Trade: A Reassessment

Many economists believe that, while openness to trade increases average GDP growth rates, it also raises output volatility by exposing countries to terms-oftrade shocks. This view does not take into account that commercial trade might also reduce financially related volatility. Once this is taken into account, the relationship between exposure to trade and output volatility is still an open question. This paper presents new empirical evidence that suggests that the net effect of trade openness on output volatility is stabilizing. The results confirm that exposure to trade raises output volatility through the terms-of-trade channel as previously documented in the literature, but also show that this is counteracted by a quantitatively larger stabilizing effect. Additional evidence is presented showing that the latter effect comes (at least in part) through the financial channel. The methodology employed seeks to correct for the likely endogeneity of trade in this setting using gravity estimates as instrumental variables.