In Discussion Paper No. 1397, Research Fellow Richard Baldwin and Research Affiliate Rikard Forslid present a direct, q-theory inspired approach to analyse growth implications of trade liberalization. The stock market value of a unit of capital is the present value of its income stream; its replacement cost is the marginal cost of new capital. In exogenous growth models, q determines the steady-state capital-labour ratio. In endogenous growth models, it determines the level of real investment. Now because endogenous growth models all make assumptions implying that a constant level of real investment yields constant growth, changes in q (or more precisely q–1) predict growth rate changes. q-1 is the shadow value of moving more resources into the capital-accumulation sector. Thus, any trade liberalization that boosts a country's q draws more resources to its accumulation sector until q is restored to unity. This raises the country's rate of capital accumulation and output growth as long as the policy does not lower the foreign q by too much.

Baldwin and Forslid focus on three openness-and-growth links, operating via an impact on the stock market value of capital (q's numerator). First, by altering the level of physical capital (for example), trade policy can expand expenditure and thereby raise the capital's stream of income. Second, when trade barriers generate government revenue that is returned to the consumer, the level of tariff revenue affects the level of expenditure and, again, of q, via the capital's rental rate. Third, reciprocal trade liberalization in financial services lowers the mark-up between the interest rates of savers and investors, thereby lowering borrowing costs and boosting q via the stock market value of a constant capital income stream. There are additional links that operate via the marginal cost of capital (q's denominator). First, trade barriers can raise replacement costs of capital and thereby lower q. Second, a lower mark-up through increased trade can reduce replacement costs and increase q. Third, localized knowledge spillovers lead to agglomeration which, in turn, reduces replacement costs and increases q. Their approach allows the study of incremental policy reform rather than mere shifts from autarky to free trade as in the early literature.

Trade Liberalization and Endogenous Growth: A q-Theory Approach
Richard E Baldwin and Rikard Forslid