DP15604 Specialization, Market Access and Real Income

Author(s):	Dominick Bartelme, Ting Lan, Andrei A. Levchenko
Publication Date:	December 2020
Date Revised:	December 2020
Keyword(s):	Gravity, k-means clustering, real income, trade specialization
JEL(s):	F43, F62
Programme Areas:	International Trade and Regional Economics, International Macroeconomics and Finance, Macroeconomics and Growth
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=15604

This paper estimates the impact of external demand shocks on real income. Our empirical strategy is based on a first order approximation to a wide class of small open economy models that feature sector-level gravity in trade flows. The framework allows us to measure foreign shocks and characterize their impact on income in terms of reduced-form elasticities. We use machine learning techniques to group 4-digit manufacturing sectors into a smaller number of clusters, and show that the cluster-level elasticities of income with respect to foreign shocks can be estimated using high-dimensional statistical techniques. We find clear evidence of heterogeneity in the income responses to different foreign shocks. Foreign demand shocks in complex intermediate and capital goods have large positive impacts on real income, whereas impacts in other sectors are negligible. The estimates imply that the pattern of sectoral specialization plays a quantitatively large role in how foreign shocks affect real income, while geographic position plays a smaller role. Finally, a calibrated multi-sector production and trade model can rationalize both the average and the heterogeneity in real income elasticities to foreign shocks under reasonable values of structural parameters.