Trade Openness and the Cost of Sudden Stops: The Role of Financial Frictions

This paper analyzes the trade policy when country spread becomes more volatile due to the possibility of sudden stops. Both analytical and numerical results show that sudden stops have weaker output impact when the small open economy is more open to trade; however, this does not imply the optimality of an open trade policy. When the economy does not pay additional expenses to adjust its foreign debt, the cost of sudden stops is decreasing in trade openness, which implies the optimality of an open trade policy. In this case, external shocks may be welfare improving. The economy will gain from counter-cyclical tariff rate policies. On the other hand, when the economy has to pay additional expenses to adjust its foreign debt, a closed trade policy is optimal. In this latter case, the nature of the policy and how the government implements the policy matter. The results hold in economies with and without the working capital constraint, and in both economies with GHH preferences and those with Cobb-Douglas preferences.