Trade and Investment under Policy Uncertainty: Theory and Firm Evidence

Kyle Handley and Nuno Limão , American Economic Journal: Economic Policy 7(4) , 189-222 , November 2015.

Using a dynamic, heterogeneous firms model with sunk costs of exporting we show that: (i) investment and entry into export markets is reduced when trade policy is uncertain and (ii) credible preferential trade agreements (PTAs) increase trade even if applied trade barriers are currently low. We structurally estimate the effect of policy uncertainty on firm entry following Portugal’s accession to the European Community in 1986 and find that (i) the trade policy reform accounted for a large fraction of the observed Portuguese exporting firms’ entry and sales (ii) the accession removed uncertainty about future EC trade policies and (iii) this uncertainty channel accounted for a large fraction of the predicted growth. These results have broader implications for other PTAs and our approach can be applied to analyze other sources of policy uncertainty.

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