A Ricardian Theory of Production, Trade and Finance - The Role of Credit Market Imperfection

We build up a Ricardian trade model for a small open economy with imperfection in the market for credit which eventually affects the pattern of production and trade. Workers/entrepreneurs are endowed with different levels “capital” and need to borrow to produce the credit intensive good. Firms with strong internal cash flow will enter the credit intensive sector. Among those the weaker ones will like to deal in fragments and the richer ones will vertically integrate. Thus distribution of capital ownership determines the nature of production and trade. Those producing fragments may engage in external as well as internal trade. Two credit constrained nations may trade in fragments. The unconstrained richer firms will follow the standard Ricardian incentive to trade. Even if trade does not require credit, shortage of production credit will affect production and trade. Later we generalize our framework to determine prices and interest rate simultaneously. Even there is no role for trade credit, financial stringency will reduce volume of production and trade.