Trade policy with asset markets: The role of financial structure for time consistency

Abstract

The present study uses a two-country, two-good, stochastic general equilibrium trade model to analyze the implications of optimal trade policy under uncertainty in the presence of financial markets. Using such a framework, I demonstrate that the policy-active home government, acting to maximize domestic welfare, will always have incentive to revise the previously announced import tariff policy once an asset position is taken by the representative agent in each country engaged in trade. The resulting time-consistent solution will be sensitive to the composition of asset income. Since the fiancial contracts can be combined in an infinite number of ways to yield the same optimal level of asset income, there will exist multiple time-consistent solutions, one for each financial structure. Using a specific log utility function, I also show that for certain financial structures, precommitment solutions will be replicated by time-consistent solutions, a result which marks a significant departure from the standard deterministic framework.