A widely held view is that openness to international trade leads to higher income volatility, as trade increases specialization and hence exposure to sector-specific shocks. Contrary to this common wisdom, we argue that when country-wide shocks are important, openness to international trade can lower income volatility by reducing exposure to domestic shocks and allowing countries to diversify the sources of demand and supply across countries. Using a quantitative model of trade, we assess the importance of the two mechanisms (sectoral specialization and cross-country diversification) and show that in recent decades international trade has reduced economic volatility for most countries.

A widely held view is that openness to international trade leads to higher GDP volatility, as trade increases specialization and hence exposure to sector-specific shocks. We revisit the common wisdom and argue that when country-wide shocks are important, openness to international trade can lower GDP volatility by reducing exposure to domestic shocks and allowing countries to diversify the sources of demand and supply across countries. Using a quantitative model of trade, we assess the importance of the two mechanisms (sectoral specialization and cross-country diversification) and provide a new answer to the question of whether and how international trade affects economic volatility. Francesco Caselli Department of Economics London School of Economics I IntroductionAn important question at the crossroads of macro-development and international economics is whether and how openness to trade a¤ects macroeconomic volatility. A widely held view in academic and policy discussions, which can be traced back at least to Newbery and Stiglitz (1984), is that openness to international trade leads to higher GDP volatility. The origins of this view are rooted in a large class of theories of international trade predicting that openness to trade increases specialization. Because specialization (or lack of diversi…cation) in production tends to increase a country's exposure to shocks speci…c to the sectors (or range of products) in which the country specializes, it is generally inferred that trade increases volatility. This view seems present in policy circles, where trade openness is often perceived as posing a trade-o¤ between the …rst and second moments (i.e., trade causes higher productivity at the cost of higher volatility). 1This paper revisits the common wisdom on two conceptual grounds. First, the paper points out that the existing wisdom is strongly predicated on the assumption that sectorspeci…c shocks (hitting a particular sector) are the dominant source of GDP volatility. The evidence, however does not support this assumption. Indeed, country-speci…c shocks (shocks common to all sectors in a given country) are at least as important as sector-speci…c shocks in shaping countries'volatility patterns (e.g. Koren and Tenreyro, 2007). The …rst contribution of this paper is to show analytically that when country-speci…c shocks are an important source of volatility, openness to international trade can lower GDP volatility. In particular, openness reduces a country's exposure to domestic shocks, and allows it to diversify its 1 See for example the report on "Economic openness and economic prosperity: trade and investment analytical paper" (2011), prepared by the U.K. Department of International Development.2 sources of demand and supply, leading to potentially lower overall volatility. This is true as long as the volatility of shocks a¤ecting trading partners are not too big, or the covariance of shocks across countries is not too large. In other words, we show that the sign and size of the e¤ect of openness on volati...