Short and long run macroeconomic effects of trade policy in the presence of debt servicing

ABSTRACT: The purpose of this paper is to analyze the macroeconomic effects of trade policy, when the instrument is a voluntary export restraint (VER), on both the home (imposing) country and the foreign (targeted) country. The innovation in the paper is the analysis of trade policy when debt servicing is present in the current account of the balance of payments. This captures the contemporary experience of deficit nations like the USA vis-à-vis surplus countries like China. Trade policy (VER) in the short-run affects the current account and exchange rate, leading to the accumulation of debt stocks, which have to be repaid in the long-run in the form of debt servicing flows. This leads to a major difference between the short and long-run effects of trade policy in the form of VERs, which can be expansionary and contractionary respectively for the trade policy initiating nation.