real exchange rates and time varying trade costs this paper re examines the empirical modeling of purchasing power parity ppp deviations in the presence of commodity market frictions first we show that a specific type of smooth transition models can closely approximate the functional form of the theoretical adjustment mechanism derived by dumas 1992 dynamic equilibrium and the real exchange rate in a spatially separated world review of financial studies 5 2153 180 for the case of constant as well as changing trade costs second we develop for the first time an empirical model of the real exchange rate which allows for changes in the degree of market integration by employing a long span of data on the dollar sterling real exchange rate and a micro founded proxy for trade frictions we provide novel evidence of a significant relationship between the persistence of the real exchange rate and the level of trade costs this finding suggests that both the difficulty of detecting ppp and the extend of rogoff s puzzle vary over time with the degree of trade restrictiveness finally we highlight policy repercussions of our results

emerging market economies and the world interest rate abstract we use a factor augmented var model to estimate the dynamic responses of interest rates in emerging market economies to the world interest rate which we extract from a dynamic factor model of yields in industrialized countries our results provide evidence that many emerging market yields respond to world rate shocks at least gradually which is broadly consistent with capital market integration our findings also suggest that the world rate captures information about emerging market yields not contained in us rates which are typically used to proxy for the world rate

capital mobility for developing countries may not be so high abstract international capital flows to developing countries have taken on considerable policy importance in recent years there is disagreement however about whether financial capital mobility has become so high that developing countries have little ability to sterilize capital flows this paper reviews several popular methods of estimating the degree of capital mobility for developing countries and shows that they are subject to potentially important upward biases due to inappropriate assumptions concerning the roles of domestic inflation and sterilization corrections for these factors can cut estimates of capital mobility by one half or more

monetary policy dollarization and parallel market exchange rates the case of the dominican republic abstract excessive money creation may give rise to inflation tax revenues and to a depreciation of the domestic currency this in turn leads to a shift away from the domestic currency into a foreign currency e g the us dollar hence the term dollarization from the domestic monetary authority s point of view dollarization is an unwelcomed phenomenomn thus the monetary authorities will attempt to arrest the dollarization phenomenon while maintaining the excessive money growth this paper develops and tests a model which analyzes the effects of monetary policy on dollarization and the parallel market exchange rates

measuring international capital mobility a review many barriers to the international movement of capital across national boundaries have been dismantled over the course of the last 20 years financial integration was greatly enhanced by the removal of capital controls on the part of the united states germany canada switzerland and the netherlands after 1973 the recycling of surpluses to developing countries through the euromarkets in the 1970 s the removal of capital controls in the united kingdom and japan beginning in 1979 financial integration among european community countries including france and italy in preparation for 1992 recent moves toward financial liberalization in smaller countries in the pacific and the steady process of technical and institutional innovation that has proceeded around the world some popular tests of international capital mobility however appear to show anomalous results martin feldstein and charles horioka upset conventional wisdom in 1980 when they concluded that changes in countries rates of national saving had very large effects on their rates of investment and interpreted this finding as evidence of low capital mobility the argument

why does sovereign risk differ for domestic and external debt evidence from scandinavia 1938 1948 abstract this study shows empirically that the political costs of sovereign default can differ considerably for domestic and external debt the analysis uses new evidence from danish and swedish bond markets around world war ii a time when markets went from being fully integrated to fully segmented overnight by linking the exogenous wartime shocks to changes in default costs on domestic and external debt it is found that these costs explain a significant part of the variation in the sovereign yield spread across markets the results suggest that governments can choose strategically on which debt the domestic or the external to default on and that this decision hinges on the relative size of the political default costs

the performance of ndf carry trades this paper investigates the performance of carry trade strategies for currencies with non deliverable forward ndf contracts we find that carry trades for currencies with ndf contracts are associated with higher sharpe ratios compared to carry trades for currencies with deliverable forward df contracts we also find that during the recent financial crisis df carry trades incur heavy losses while ndf carry trades realize insignificant losses df carry trade payoffs are shaped by credit risk global foreign exchange fx volatility and crash risk in contrast ndf carry trade payoffs are driven by global fx volatility and crash risk liquidity risk and currency convertibility risk measured by deviations from covered interest parity in offshore markets while global convertibility risk has a limited effect on carry trades

the minimal conditions for a financial crisis a multiregional intertemporal cge model of the asian crisis abstract the globalization of world capitalism constrains the ability of the developmental state to pursue an independent industrialization and foreign trade strategy we use an intertemporal multiregion cge model to study the fundamental reasons for a financial crisis we find that we can create a realistic crisis in the asia region when capital markets are open and there is an unexpected rise in the risk premium of the asia region when capital markets are closed and the state retains all its policy instruments the asia region not only avoids a crisis but increases its rate of growth

the politics of foreign direct investment into developing countries increasing fdi through international trade agreements the flow of foreign direct investment into developing countries varies greatly across countries and over time the political factors that affect these flows are not well understood focusing on the relationship between trade and investment we argue that international trade agreements gatt wto and preferential trade agreements ptas provide mechanisms for making commitments to foreign investors about the treatment of their assets thus reassuring investors and increasing investment these international commitments are more credible than domestic policy choices because reneging on them is more costly statistical analyses for 122 developing countries from 1970 to 2000 support this argument developing countries that belong to the wto and participate in more ptas experience greater fdi inflows than otherwise controlling for many factors including domestic policy preferences and taking into account possible endogeneity joining international trade agreements allows developing countries to attract more fdi and thus increase economic growth

social protection and economic integration the politics of pension reform in an era of capital mobility in the past two decades of the 20th century governments around the world began to apportion greater responsibility for old age income provision to individuals and market forces through the privati

interest rates risk and imperfect markets puzzles and policies traditional theory emphasizes the key role that monetary policy can play through the manipulation of interest rates but there are several puzzles that cannot be reconciled with standard models these include the apparent constancy in interest rates over extended periods and changes at other times which appear unrelated to changes in technology and demography the cyclical pattern of movements in real interest rates the impact of nominal not real interest rate changes on real variables and the cyclical pattern of movements in interest rate spreads this paper reaches beyond the standard competitive equilibrium perfect information model of credit markets towards imperfect information models particularly those that focus on the determinants of bank behaviour of the standard models the money demand model is most deficient in understanding these puzzles the loanable funds theory and a generalized version of real productivity theory can be reconciled with imperfect information and markets and the consequent credit and equity rationing regimes help to explain the puzzles specifically banks may be insensitive to changes in monetary stance owing to risk aversion there are strong policy implications it is argued for instance that in east asia raising interest rates exacerbated economic decline and rather than contributing to exchange rate stability may have induced capital flight as default risk increased lowering risk adjusted expected returns

measuring financial market integration over the long run is there a u shape abstract using long time series for sovereign bond markets of fifteen industrialized economies from 1875 to 2009 i find that financial market integration by the end of the 20th century was higher than in earlier periods and exhibited a j shaped trend with a trough in the 1920s the main reason for the higher financial integration seen today is the recent extensive globalization around the turn of the 20th century countries frequently drifted apart conversely in recent years the bond markets of most countries have moved together both policy variables and the global market environment play a role in explaining the time variation in integration while unexplained changes in the overall level of country risk are also empirically important my methodology based on principal components analysis is immune to outliers and accounts for global and country specific shocks and hence can capture trends in financial integration more accurately than standard techniques such as simple correlations

currency substitution the recent experience of bolivia abstract one of the more puzzling aspects of bolivia s economic performance since 1986 has been the rapid increase in the share of foreign currency deposits in the domestic banking system that has occurred notwithstanding low inflation rates and a high degree of external stability an analysis of the determinants of currency substitution in bolivia shows that economic variables are statistically significant but have a fairly low explanatory power compared to variables that measure the degree of inertia in the currency substitution process hence conventional fiscal and monetary measures may not be sufficient to reverse the process of currency substitution this points toward an interesting asymmetry where currency substitution increases rapidly with macroeconomic instability but is difficult to reverse even after years of macroeconomic stability

international interest rate linkages and the exchange rate regime abstract return differentials between instruments denominated in canadian dollars and instruments denominated in american dollars are investigated the study compares the properties of return differentials in the period of fixed exchange rates during the 1960s and in the period of flexible exchange rates during the 1970s and 1980s both real and nominal return differentials are investigated the results indicate that the change in exchange rate regime is not associated with a change in the average level of ex post return differentials between canada and the united states models which predict ex ante return differentials from available information in a rational expectations framework show a surprisingly large amount of structural stability across the regime change the major impact of the flexible exchange rate regime is on the variance of ex post return differentials and not on the average level of ex post or ex ante return differentials jel e42 e58 g15

real exchange rate behavior the recent float from the perspective of the past two centuries using annual data spanning two centuries for dollar sterling and franc sterling real exchange rates we find strong evidence of mean reverting real exchange rate behavior using simple stationary autoregressive models estimated on prefloat data we easily outperform nonstationary real exchange rate models in dynamic forecasting exercises over the recent float such stationary univariate equations explain 60 80 percent of the in sample variation in real exchange rates although the degree of short run persistence may be high the econometric estimates imply a half life of shocks to the real exchange rate of about 6 years for dollar sterling and a little under 3 years for franc sterling

financial development and economic growth convergence or divergence abstract this study tests for convergence in financial development and economic growth by incorporating the interaction between the real and financial sectors into an otherwise traditional test for convergence the results show strong evidence for conditional convergence middle and high income countries conditionally converge to parallel growth paths not only in per capita gdp but also in financial development the mutually reinforcing relationship between financial development and economic growth is stronger in the early stage of economic development and this relationship diminishes as sustained economic growth gets under way as such low income countries with a relatively well developed financial sector are more likely to catch up to their middle and high income counterparts and those with a relatively under developed financial sector are more likely to be trapped in poverty this finding explains the observed great divergence between poor and rich countries another finding is that while human capital is more important to growth in the early stage of economic development economic freedom becomes more important in the later stage

does economic diplomacy work a meta analysis of its impact on trade and investment we review the literature on economic diplomacy and provide a meta analysis of 32 empirical studies published in 1986 2011 that deal with the trade and investment impact of economic diplomacy embassies consulates other diplomatic facilities investment and export promotion offices trade and state visits controlling for differences in research design methodology time frame and manner of data we find a positive and significant effect of economic diplomacy on international economic flows with the exception of state visits and that this is true in a sample of 627 t statistics analysed with ols and for a larger sample of 963 reported significance levels analysed with logit thus illustrating robustness with respect to sample and estimation technique our analyses show that reported effects of economic diplomacy on trade and investment in individual studies are sensitive to model specification the primary studies that investigate only one source country are less likely to report significant positive effects compared to other sciences economic studies are less likely to report significantly positive effects of economic diplomacy primary studies lump embassies and consulates general into one indicator miss that these instruments differ significantly embassies consulates and agencies should thus be included as separate instruments in future research

international overborrowing a decomposition of credit and currency risks summary the severity of the financial crises enveloping the tiger economies of southeast asia in 1997 came as a surprise to many observers this paper uses a simple fisherian model of the overborrowing syndrome to compare the asian crises of 1997 with earlier overborrowing episodes in mexico and chile while important similarities exist the crises in southeast asia have been exacerbated by the unhedged foreign exchange positions of asian banks these open currency positions not only imposed significant additional losses on the banks following devaluation they also magnified the scale of overborrowing during the cycle s initial boom phase failure to limit the exposure of banks to foreign exchange risk therefore increased the magnitude of the boom bust overborrowing cycle both ex ante and ex post the paper highlights the importance of effective regulation and supervision of capital markets with a focus on limiting the speculative currency positions of banks especially those that form the core of the domestic payments system and therefore enjoy a possibly implicit public guarantee improving the institutional infrastructure of financial supervision is the only effective way of mitigating the macroeconomic costs of overborrowing

real interest rate equalization and the integration of international financial markets abstract this paper argues that conventional regression tests of real interest rate equality may be misleading because they neglect to consider transactions costs a transactions cost band may inhibit the one to one correspondence between changes in real rates in alternative countries that is presumed by conventional tests statistical problems which may lead to incorrect inferences in conventional tests are also discussed alternative tests which overcome these limitations are developed and applied to real interest rates for ten different countries the alternative tests generate much stronger support for interest parity than is found in the existing literature

purchasing power parity and the behavior of prices and nominal exchange rates across exchange rate regimes abstract the evidence presented in this paper shows that purchasing power parity as a long run proposition is indeed a very useful approximation we see this quite clearly in the panel data for three historical periods examined here the classical gold standard era from 1870 to 1914 the interwar period from 1921 to 1939 and the period after world war ii from 1959 to 1998 price level behavior across countries differs in the way that ppp suggests when monetary arrangements differ and is highly similar when monetary arrangements are themselves similar inflation rates adjusted for exchange rate changes in general are highly correlated and bear a one to one relation to one another within and across the three periods and the varied monetary regimes that prevailed

the effects of real wages and labor productivity on foreign direct investment the volume of foreign direct investment fdi both into and out of the united states has grown rapidly in the past several decades theoretically labor costs in both source and host countries could be important determinants of these flows but thus far no consistently significant effects have been reported for fdi flows between the u s and other industrialized countries in this paper i estimate equations for u s fdi flows to and from five other industrialized countries the explanatory variables include both source and host country real wages and labor productivity but to put my work in perspective i shall first in section ii discuss recent literature in the area then section iii briefly discusses a theoretical model to highlight the possible effects of the labor variables the empirical procedure and results are presented in section iv and a summary in section v

capital mobility and the relationship between saving and investment rates in oecd countries abstract this paper considers tests that use data on saving and investment rates to determine the degree of international capital mobility two types of evidence are presented to show that a high correlation between saving and investment rates across oecd countries can be consistent with a high degree of capital mobility this evidence qualifies the conclusions of previous studies and casts doubt on the usefulness of testing hypotheses about capital mobility with data on saving and investment rates

reversal of fortunes democratic institutions and foreign direct investment inflows to developing countries does increased democracy promote or jeopardize foreign direct investment fdi inflows to less developed countries we argue that democratic institutions have conflicting effects on fdi inflows on the one hand democratic institutions hinder fdi inflows by limiting the oligopolistic or monopolistic behaviors of multinational enterprises facilitating indigenous businesses pursuit of protection from foreign capital and constraining host governments ability to offer generous financial and fiscal incentives to foreign investors on the other hand democratic institutions promote fdi inflows because they tend to ensure more credible property rights protection reducing risks and transaction costs for foreign investors hence the net effect of democracy on fdi inflows is contingent on the relative strength of these two competing forces our argument reconciles conflicting theoretical expectations in the existing literature empirical analyses of fifty three developing countries from 1982 to 1995 substantiate our claims we find that both property rights protection and democracy related property rights protection encourage fdi inflows after controlling for their positive effect through property rights protection democratic institutions reduce fdi inflows these results are robust against alternative model specifications statistical estimators and variable measurements

dollarization in post hyperinflationary argentina abstract this paper analyzes the continued dollarization of the argentine economy which experienced a rapid decline in inflation following its hyperinflations of the 1980s first a measure of dollar currency circulating in argentina is developed thereby improving upon previous studies of dollarization and currency substitution that focused on dollar deposit holdings only second cointegration analysis of peso money demand in argentina finds a negative ratchet effect from inflation the reduction in peso money demand attributable to the ratchet mirrors the estimated stock of all dollar assets held domestically by argentine residents consistent with the hypothesis of irreversible dollarization

state visits and international trade politicians travel extensively abroad for various reasons one purpose of external visits is to improve bilateral economic relations in this paper i examine the effect of state visits on international trade i use a large data set covering the travel activities of the heads of state of france germany and the united states between 1948 and 2003 my results indicate that state and official visits are indeed positively correlated with exports a typical visit is associated with higher bilateral exports by about 8 to 10 per cent holding other things constant

aid governance and private foreign investment some puzzling findings for the 1990s does official aid pave the road for private foreign investment or does it suffocate private initiative by diverting resources towards unproductive activities we explore this question using panel data covering a large number of developing and emerging economies during the 1990s controlling for countries institutional environment we find that evaluated at the mean the marginal effect of aid on private foreign investment is close to zero surprisingly however the effect is strictly positive for countries in which private agents face a substantial regulatory burden this result is robust across a wide range of specifications samples and estimation methods

real interest parity rip over the 20th century new evidence based on confidence intervals for the largest root and the half life abstract in this paper we employ local to unity asymptotics to investigate the validity of real interest parity rip for three countries relative to the us using long span data we find that deviations from parity are corrected quickly and this is what could in principle be expected to happen in an integrated world where economic forces act rapidly so that discrepancies do not grow systematically over time moreover the observed speed of reversion raises important issues for policy in that the tendency for rates to converge implies that the impact of the domestic authorities stabilization polices might be limited finally there is no clear cut difference in the adjustment to shocks across fixed and floating regimes

estimating saving investment correlations evidence for oecd countries based on an error correction model abstract saving investment correlations are important stylized facts in open economy macroeconomics and indicators of capital mobility they are best estimated by an error correction model ecm because an ecm is consistent with intertemporal general equilibrium models the ecm is a synthesis of previous approaches applying the ecm to the oecd countries we find that in general saving and investment are cointegrated the ecm is more powerful in detecting cointegration than the two step engle granger procedure estimates of the saving investment correlation are robust with respect to overdifferencing we find evidence of a large country effect and an increase in capital mobility within the oecd area

the dollarization of latin america as a market enforced monetary reform evidence and implications monetary reforms are a response to past and present monetary conditions yet what happens when public confidence in the domestic currency is eroded but the government does not declare an official monetary reform it is likely that the public will substitute away from the low confidence domestic currency into a high confidence foreign currency to the extent that such substitutions are possible in other words as confidence in the domestic money declines money demanders will tend to substitute away from domestic money in favor of foreign money this is in effect a market based monetary reform on the demand side in place of an official supply side monetary reform this paper will consider such demand side substitutability in latin america and the official response monetary historians have chronicled many instances of monetary reform when an existing low confidence currency is replaced by a new monetary unit while historical episodes differ in regard to social and political circumstances it is safe to say that the economic circumstances leading to reform can be traced to a high and unstable rate of growth of the money supply for instance on september 29 1975 chile replaced the escudo with the chilean peso where one peso was defined as being equal to 1 000 escudos the chilean money supply had grown at an annual rate of 121 from 1971 to the time of the reform argentina introduced a new monetary unit the peso argentino on june 1 1983 where one new peso argentino was defined as being equal to 10 000 old pesos the argentine money supply had grown at an annual rate of 85 since 1979 these growth rates prior to monetary reform are substantially higher than the average latin american money growth rate over the 1972 83 period of 40

dollar currency in latin america a bolivian application abstract the stock of u s dollar currency held in bolivia is estimated using two alternative methods incorporating estimated dollar currency balances in m 2 results in more reasonable movements in velocity than the unbelievable gyrations in official velocity

the internationalization of money and finance and the globalization of financial markets abstract in this paper i combine long multi country time series data for interest rates and stock returns with the institutional evidence for much earlier centuries amassed by economic historians to study the question of financial globalization and how it has altered since the late classical era at their longest for dutch and english short term interest rates the quantitative data that i use extend back slightly more than three centuries the institutional history provides information on an additional millennium s worth of experience the conclusion that i reach is that the internationalization of money and finance and the globalization of financial markets are not new phenomena they are part of an evolutionary process that began much earlier and that has continued albeit with periodic interruptions and reversals for many centuries what we see today is simply the latest and most advanced manifestation of this process

on the link between japanese oda and fdi in china a microeconomic evaluation using conditional logit analysis this study investigates the effectiveness of japan s official development assistance in promoting foreign direct investments inflows in the case of the people s republic of china conditional logit analysis using province level statistics from 1980 to 1999 shows that japanese aid flows did have a significant positive impact on private investors location choice even though other profit maximizing factors such as the level of economic activity had a leading spillover effect in a context of growing scarcity of aid the study concludes by asserting the importance of a complementary process in which foreign aid is aimed at enhancing the development of infrastructures acting as a pre requisite for future direct investments finally japan providing an interesting case study we stress the need for a better cooperation between public and private sectors in development assistance programmes

a functional coefficient model view of the feldstein horioka puzzle what does the saving investment si relation really measure and how should the si relation be measured these are two of the most discussed issues triggered by the so called feldstein horioka puzzle based on panel data we introduce a new variant of functional coefficient models that allows to separate long and short to medium run parameter dependence the new modeling framework is applied to uncover the determinants of the si relation macroeconomic state variables such as openness the age dependency ratio government current and consumption expenditures are found to affect the si relation significantly in the long run

currency substitution in mexico the dollarization problem the term dollarization will be interpreted in this paper as the degree to which real and financial transactions are performed in dollars relative to those realized in domestic currency an obvious choice for measuring the degree of dollarization in the economy is the proportion of dollars to domestic currency circulating at any point in time this concept of dollarization is closely related to the literature on currency substitution which explains the conditions under which foreign money balances will be held and adapted to expected changes in relative risks and returns among the various currencies the general idea of several representative recent papers see 6 9 12 is that monetary policy will be ineffective in a country where foreign currencies are regarded as good substitutes for domestic currency an implication of this hypothesis is that the elasticity of substitution between domestic and foreign currencies is likely to increase in periods when the exchange rate is floating hence if the issue of currency substitution is empirically relevant one of the stronger arguments for floating exchange rates greater national monetary independence is seriously weakened

does foreign aid increase foreign direct investment summary we examine the idea that aid and foreign direct investment fdi are complementary sources of foreign capital we argue that the relationship between aid and fdi is theoretically ambiguous aid raises the marginal productivity of capital when used to finance complementary inputs like public infrastructure and human capital investments but aid may crowd out private investments when it comes in the shape of pure physical capital transfers empirically we find that aid invested in complementary inputs draws in fdi while aid invested in physical capital crowds it out the paper shows that the composition of aid matters for its overall level of efficiency

the euro and european financial market dependence a time varying copula model is used to investigate the impact of the introduction of the euro on the dependence between 17 european stock markets during the period 1994 2003 the model is implemented with a gjr garch ma t model for the marginal distributions and the gaussian copula for the joint distribution which allows capturing time varying non linear relationships the results show that within the euro area market dependence increased after the introduction of the common currency only for large equity markets such as in france germany italy the netherlands and spain structural break tests indicate that the increase in financial market dependence started around the beginning of 1998 when euro membership was determined and the relevant information was announced the uk and sweden but not other european countries outside the euro area are found to exhibit an increase in equity market co movement which is consistent with the interpretation that these countries may be expected to join the euro in the future

inflation and financial sector size abstract traditionally the cost of expected inflation has been seen as the shoeleather cost of going to the bank more often this paper focuses on the other side of these transactions i e on the increased production of financial services i construct a model in which households must make purchases either with money or with costly transactions services produced by firms in the financial services sector in the model a higher inflation rate leads households to substitute purchased transactions services for money balances thereby boosting the size of the financial services sector a test of the model using cross sectional data finds that the size of a nation s financial sector is strongly affected by its inflation rate the empirical results provide an alternative way to measure the costs of inflation these costs appear to be large

international investment location decisions abstract in international location tournaments governments compete for foreign investment with tax and other short run incentives such tournaments can be won if agglomeration economies are sufficiently powerful to overcome investors desire to spread investments as a hedge against risk we focus on manufacturing investments by u s multinationals in the 1980s our econometric results suggest that agglomeration economies are indeed the dominant influence on investor calculations paradoxically short run incentives have limited apparent impact on location choice we conclude that high cost tournament play is unnecessary for countries with good infrastructure development specialized input suppliers and an expanding domestic market

the relationship between domestic savings and investment the feldstein horioka test using japanese regional data abstract the feldstein horioka test on capital mobility applies to japanese intra national capital flows we find that savings and investment are insignificantly correlated this suggests that the high correlation observed by the previous studies is due to the currency premium

wage effects of labour migration with international capital mobility wage effects of immigration are investigated in a setting with international capital mobility which eliminates two thirds of the native wage effects of immigration without international capital mobility overall gains from migration in the immigration region are only a small fraction of total losses to native workers but with perfect international capital adjustment overall gains are larger than total losses to native workers two alternative tax policies to eliminate the negative wage effects of immigration on low skilled native workers are evaluated

is foreign aid a vanguard of foreign direct investment a gravity equation approach summary this paper investigates whether and how foreign aid facilitates foreign direct investment fdi flows into less developed countries we employ a large data set of source recipient country pairs and conduct gravity equation type estimation our empirical methodology enables us to examine an effect through which aid from a donor country promotes fdi from the same donor in particular which we call a vanguard effect we find that foreign aid in general does not have any significant effect on fdi however when we allow for differences in the size of aid effects across donor countries we find robust evidence that foreign aid from japan in particular has a vanguard effect i e japanese aid promotes fdi from japan but does not attract fdi from other countries

trade policy and productivity abstract previous studies on the determinants of productivity emphasized the role of trade and institutions but omitted trade policy due to endogeneity concerns this paper considers the role of one important element of trade policy free trade agreements ftas based on recent work on the determinants of ftas we suggest an instrument which is based on the propensity to enter an fta due to exogenous geographical characteristics we find that differences in institutional quality and trade due to variations in geography and trade policy have a sizeable effect on productivity and can explain the huge variation in per capita income across countries