IMES DISCUSSION PAPER SERIESThe Global Impact of Chinese GrowthIppei Fujiwara, Keisuke Otsu, and Masashi Saito
Discussion Paper No. 2008-E-22

INSTITUTE FOR MONETARY AND ECONOMIC STUDIESBANK OF JAPAN
2-1-1 NIHONBASHI-HONGOKUCHOCHUO-KU, TOKYO 103-8660
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IMES Discussion Paper Series 2008-E-22
September 2008

The Global Impact of Chinese GrowthIppei Fujiwara*, Keisuke Otsu**, and Masashi Saito***
Abstract

Three decades have passed since China dramatically opened up to the global market andbegan to catch up rapidly with leading economies. In this paper we discuss the effects ofChina’s opening-up and rapid growth on the welfare of both China and the rest of theworld (ROW). We find that the opening-up per se is welfare improving for China but
has had little impact on the ROW given a balanced trade constraint. The opening-up of
China is beneficial to the ROW if it leads to significant productivity growth in China.
Also, China’s balanced trade policy after the opening-up has helped the ROW rather
than China.
Keywords: Productivity; Terms of Trade; Growth; Open Economy
JEL classification: E13, F41, O47*Director and Senior Economist, Institute for Monetary and Economic Studies, Bank of Japan(E-mail: ippei.fujiwara@boj.or.jp)**Assistant Professor, Sophia University, Faculty of Liberal Arts and formerly, Economist,
Institute for Monetary and Economic Studies (E-mail: k-otsu@sophia.ac.jp)***Economist, Research and Statistics Department, Bank of Japan (E-mail:masashi.saitou@boj.or.jp)
The authors would like to thank Maurice Obstfeld, Bennet McCallum, Toni Braun, Chang-Tai
Hsieh, Mick Devereux, Gary Hansen, Stanley Cho, Mark Wright, Fabio Ghironi, GiancarloCorsetti, Warwick McGibbin, Lee Ohanian, Selo Imrohoroglu, Michael Woodford andparticipants at the 2007 Reserve Bank of Australia Workshop, 15th Bank of Japan International
Conference and GRIPS Seminar in Economics for helpful comments. The authors also thankNaoko Hara and Andrea Raffo for technical advice. Views expressed in this paper are those of
the authors and do not necessarily reflect the official views of the Bank of Japan.

1Introduction

China’s output growth suddenly took o¤ in 1978. This corresponds to thesudden increase in “openness”, i.e. the trade volume to GDP ratio. The
rest of the world (ROW), which we de…ne as the aggregate of the G7 countries, grew constantly over the 1950-2005 period regardless of the dramatic
opening-up and take-o¤ of China. Shouldn’t the ROW be a¤ected by theentry of China? In this paper, we use a standard two-country neoclassicalmodel to quantitatively assess the global e¤ects of the shocks to China andshow that the opening-up can be welfare improving for both China and the
ROW if it leads to signi…cant productivity growth.
The key facts of the Chinese economy are threefold. First, soon after the“Reform and Opening-up” policy was enacted in 1978, the trade volume to
GDP ratio increased roughly from 0:1 to 0:4. Second, the annual growth rateof per capita GDP was around 2.5% until 1978 then jumped to roughly 8%
on average over the 1978-2004 period. Finally, trade was roughly in balancethroughout the pre-1978 period. In this paper, we identify shocks which
replicate these facts in the Chinese economy and deduce their impacts on
the ROW within a standard neoclassical two-country two-good model à la
Backus, Kehoe and Kydland (BKK(1994)).
Several studies have assessed the importance of TFP in explaining the
rapid growth in post-1978 China. Dekle and Vandenbroucke (2006) argued
that the shift in labor from agriculture and public non-agriculture sectors
to private non-agriculture sectors was a major contributor to the growth
in TFP. On the other hand, Young (2003) claimed that the growth rate of
the non-agricultural economy is “respectable but not outstanding”. Islam,
Dai and Sakamoto (2006) computed TFP growth with the dual approach
introduced by Hsieh (2002) and found that the post-reform Chinese TFP
growth was high but has recently decelerated. The main focus of these studies
is China’s domestic growth. There have also been studies on the impactof China’s entrance into the world trade market. For instance, Coleman(2007) showed using a static model that the entrance of China caused aninternational production adjustment among neighbor countries through its
e¤ect on international relative prices. In this paper, we combine the two linesof literature and assess the dynamic e¤ect of the opening-up and growth of
China on the ROW within a dynamic general equilibrium setting.
The fact that the ROW did not seem to be a¤ected by the large shocks
in China is surprising given that China is the largest country in the world in1

terms of population and second largest in terms of PPP adjusted total GDP.
In a two-country one-good model such as Baxter and Crucini (1995), there
should be a high correlation between consumption growth across countries.
However, practically no consumption risk-sharing between China and theROW seems to have taken place. Thus, we consider a two-country two-goodmodel in which the terms of trade provide a cushion for consumption risksharing. Each country trades intermediate goods that are aggregated witha constant elasticity of substitution technology in order to satisfy aggregate
demand. The aggregation technology is characterized by the elasticity of
substitution between home goods and foreign goods as well as the degree ofhome goods weight.
The two key shocks to the Chinese economy that we assume are shocks
to the weight of domestically produced intermediate goods in …nal goods
production and the gradual productivity growth in the Chinese intermediate goods …rms. The home goods weight a¤ects the share of home goods
among the total intermediate goods used to produce domestic …nal goods.
We attribute the opening-up policy to a sudden fall in this weight, whichleads to an increase in openness. Productivity growth should be importantin explaining the output growth in China since there is no evidence of capital
deepening during the rapid growth period, unlike in many East Asian countries. In addition to the two key shocks, we also assume a balanced trade
constraint in our model. Prior to the reform in 1978, Beijing imposed several
direct regulations on trade and the imports of targeted goods were …nancedby exports of products redundant in the domestic market. For simplicity, we
assume that the Chinese government imposed tari¤s on imports in order tomaintain balanced trade. Since data on tari¤s in the context of our model
is not available, we simply calculate the as-if tari¤s needed to maintain balanced trade. The justi…cation for this constraint is perhaps less convincing
for the post-1978 period as China gradually reduced tari¤ rates and removed
non-tari¤ barriers following GATT and WTO protocols. However, we do …nd
some evidence suggesting that some sort of import restriction existed evenafter the opening-up.
Since we cannot directly observe the home goods weight and intermediate
goods …rm productivity, we deduce them by matching the openness andoutput in China implied from the model with a balanced trade constraint to
the data. Indeed, the home goods weight suddenly drops and intermediate
goods productivity growth takes o¤ in 1978 as expected. We simulate themodel given the computed values of home goods weight and productivity.
2

Our results show that the sudden reduction in China’s home goods weight
is welfare improving for China but has little impact on the ROW. On theother hand, the productivity growth in China is welfare improving for both
economies. Therefore, we conclude that the opening-up policy is welfare
improving for both economies if it leads to signi…cant productivity growth.
We also conduct a simulation without the balanced trade constraint and …ndthat China would have been better o¤ without the constraint while the ROW
would have been worse o¤. Thus, the balanced trade constraint helps the
ROW rather than China.
The rest of the paper is organized as follows. In section 2, we document
the data on China focusing on the opening of trade and the growth in GDP
components. In section 3, we describe the model. In section 4, we present
the quantitative results. Section 5 concludes the paper.

2

The Opening-up and Growth of China

In this section, we describe the key features of the Chinese economy over the
1950-2004 period. The source of most data is from Penn World Table 6.2
and is stated otherwise.

2.1

Openness

Figure 1 presents the “openness” of China de…ned as Trade Volume/GDP
in real terms1 . The sudden increase in trade in 1978 corresponds to thebeginning of the “Reform and Opening-up (Gaige Kaifang) policy”. The
entry of China to the World Trade Organization in 2001 surely increased thetrade volume, however, historically speaking, the opening-up policy had amuch greater impact on openness.
1

Note that this measure includes trade with non G7 countries as well.

3

Figure 1. China’s Openness
60

50

40

30

20

10

0
1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

As described in Shirk (1994), the main aim of trade policy prior to 1978
was import-substitution. The government especially protected the steel andmachinery industries from foreign competition by controls on imports, investment, capital ‡ows and exchange rates. Trade was limited to the central
foreign trade ministry and its twelve trade corporations. They exported
agricultural and primary goods in order to …nance the controlled imports ofmainly industrial equipment. In 1978, as a part of the reform, four cities werenamed special economic zones and invited foreign direct investment while
the number of institutions licensed to trade was dramatically increased. The
opening-up not only increased trade but also changed the composition of
goods traded as the economic zones started to export goods in which they
had competitive advantage, namely labor intensive goods, and imports ofconsumer durables increased dramatically. Throughout this paper, we treat
all …nal goods as the same and evaluate them at PPP adjusted levels following
PWT 6.2.

4

2.2

GrowthFigure 2 presents GDP per economically active population (EAP)2 in China
and the ROW. The series are in log terms and linearly detrended with theaverage annual growth rate of the ROW GDP per EAP 2:5%.
Figure 2. Output
10

9

8

7

6

5
1950

1955

1960

1965

1970

1975

1980

China

ROW

1985

1990

1995

2000

This …gure shows that China was growing roughly at the same rate as
the ROW prior to the opening-up. Once the economy opened up, China’s
growth rate took o¤. The average annual growth rate during the post-reformperiod is nearly 8% while it was roughly 2:5% during the 1950-1978 period.

2.3

Trade Balance

Figure 3 presents China’s real trade balance to GDP ratio. For comparison,
we also provide the nominal measure which is not a¤ected by ‡uctuations inprice de‡ators. The trade balance is a tricky variable for two reasons. First,
as for the openness, since we omit many countries, the trade balance of the
ROW is not exactly the mirror image of the trade balance of China. Since
2

This series correspond to GDP per worker in PWT 6.2 where PWT de…nes “worker”
as the economically active population.

5the trade balance of the ROW is not a variable in which we are interested,
we focus only on China’s trade balance. Second, it is tricky to convert thetrade balance into real terms. One way is to simply compute it as a residualfrom the GDP expenditure identity using real output, consumption and investment. Another way, introduced by Feenstra, Heston, Timmer and Deng
(2007), is to denominate exports and imports by their PPP adjusted weighted
price indexes3 . We follow the latter method since we are interested in thereal value of trade, both the trade balance and openness, and the e¤ects ofshocks operating through the real terms of trade channel.
Figure 3. China’s Trade Balance
10

5

0

-5

-10

-15
1950

1955

1960

1965

1970

1975

1980

Real

Nominal

1985

1990

1995

2000

Clearly, there is no trend in the trade balance to GDP ratio prior to 1978.
There are some large ‡uctuations in the trade balance in 1985 and 1990 andthere is a persistent trade surplus in China during the 90s. In 1985 thegovernment allowed trade related …rms to make their own trade and production plans, which led to a sudden increase in imports of investment goods.
In 1987, the government introduced an import substitution policy that immediately eliminated the trade de…cit. This leads us to believe that trade3

Thus our measure of GDP is expenditure based PPP adjusted real GDP. The samemeasure of real exports and imports is used to compute real openness. A thorough discussion of this matter can be found in Feenstra, Heston, Timmer and Deng (2007).

6was controlled by the government even after the opening-up. After 1994,
the trade balance turned to surplus due to Chinese exchange rate control infavor of exports. This can also be considered as an indirect trade control.
We do not deal with these individual episodes but instead argue that there
must have been some pressure which forced trade to be almost balanced, orat least non-negative, throughout the whole period4 . We show later in thequantitative analysis section that otherwise there would have been a large
trade de…cit.

2.4

The Demand Side

Figure 4 presents the GDP components. Consumption per EAP includes
private and government …nal consumption expenditure. Investment per EAP
includes private and government …xed investment. Both of these series arelinearly detrended with the same rate as GDP per EAP.
Figure 4. GDP Components
Consumption
10

9

8

7

6

5
1950

1955

1960

1965

1970

1975

1980

China

ROW

4

1985

1990

1995

2000

The huge trade surplus in 1990 seems to be merely re‡ecting the mild recession in
1988-89 which most likely led to a drop in imports.

7

Investment
9

8

7

6

5

4

3
1950

1955

1960

1965

1970

1975

1980

China

ROW

1985

1990

1995

2000

Clearly, Chinese consumption took o¤ in 1978 as GDP did whereas thetrend-break in investment is some what less obvious. The interesting pointis that there is no correlation between consumption in China and the ROW.
This implies that there must have been large changes in relative prices between goods in China and the ROW which prevented international consumption risk-sharing.5 .

2.5

The Supply Side

Figure 5 provides estimates of capital output ratios and data on labor. Capital output ratio is computed from data either in PPP adjusted real terms orin local real prices depending on the dataset6 . Labor stands for the numberof people employed divided by EAP.
5

In a two-country one-good model, the relative price is always one, which leads tostrong correlation between consumption in both countries. For instance, if the periodical
utility function is in the form of:u=log ct + (1) log(1lt )in both countries, there should be perfect correlation between consumption growth in bothcountries.
6
For the Nehru and Dhareshwar (1993) data, the ROW series is a population weighted
average of capital-output ratios. For Penn World Tables, since the variables are in the8Figure 5. Production Factors
Capital Output Ratio
4
3.5
3
2.5
2
1.5
1
0.5
0
1950

1955

1960

1965
ND-ROW

1970

1975

ND-China

1980

1985

1990

1995

PWT-ROW

Hsieh-China

1980

1990

2000

2005

Labor
0.7

0.6

0.5

0.4

0.3

0.2

0.1
1950

1955

1960

1965

1970

1975
China

1985

1995

2000

ROW

same unit, the ROW series is simply the sum of capital stock divided by the sum of output.
For the Bai et al. (2006) data, we use the investment goods de‡ator to compute the realcapital to GDP ratio.

9

We plot capital stock estimation from several sources. Nehru and Dhareshwar (ND (1993)) reported real capital stock in 1987 local prices. According
to the ND (1993) estimates, the average capital-output ratios over the 19501990 period are 2.5 in the ROW and 2.4 in China. Another widely used source
is PWT 5.6 which reports capital stock per worker in 1985 international dollars7 . According to PWT 5.6, the capital-output ratio for the 1965-1990 period in the ROW is 1.01. However, it does not report capital stock estimatesfor China. Bai, Hsieh and Qian (2006) reported nominal capital-output ratioin China over the 1978-2005 period. Adjusting for relative prices, the averagereal capital-output ratio in 1978 yuan is 1.45. According to ND (2003), thecapital-output ratio in China is similar to that in the ROW. Although thelevel of the ratio depends on the currency unit and the base year used, both
ND (1993) and Bai, Hsieh and Qian (2006) imply that there is no noticeable
growing trend in the capital-output ratio. This means that the growth inChina has not been driven by rapid capital accumulation8 .
Usually labor refers to total hours worked which consists of hours worked
per worker and the number of workers employed. However, data on hours
worked is not available in China and several ROW countries. Thus, we
use the civilian employment data from OECD as a proxy for labor input9 .
Employment per EAP in the ROW is roughly stable and slightly increases
throughout the period. Employment per EAP in China jumps in 1990 due
to a revision in the statistics.
Given estimates of capital stock and data of output and labor, we cancompute a crude measure of aggregate TFP from a production function
Yt = Kt (At lt )1
where is the capital share, A1t is aggregate TFP and Yt , Kt and lt are output, capital and labor per EAP. The measure is “crude”in several respects.
First, as shown above, there are discrepancies in the capital stock data acrossdatasets. We construct the capital stock series using the capital-output ratio
in 1952 from ND (1993) and the perpetual inventory method assuming a 3.5
7

PWT uses the Heston-Summers method for PPP adjustment. They have not yet
updated the capital per worker series in version 6.2.
8Young (1995) showed that rapid growth in emerging East Asian economies during the
70s and 80s was driven mainly by rapid capital accumulation.
9
For France, we use the LABORSTA database from the International Labor Organization.

10

percent depreciation rate in both countries10 . Second, as mentioned above,
data on hours worked per worker is not available for China. Since we use
the employment data as a proxy for total hours worked (labor), our measureof aggregate TFP includes changes in hours worked per worker. Even theemployment data in China is not reliable since there is a data break which
will cause a jump in aggregate TFP. Finally, whereas we assume standard
Cobb-Douglas production functions for both the ROW and China, capitalshares might di¤er across countries. This is especially problematic in aggregating TFP for the ROW. Following Gollin (2002), we use one-third as acommon capital share for the ROW and China and thus avoid this issue.
Figure 6 plots our measure of aggregate TFP detrended with the same
linear trend as in Figure 2. We can clearly see that the take-o¤ of Chinese
output coincides with a take-o¤ of aggregate TFP. The average growth rates
of TFP in the ROW and China were 2.7 percent and 2.3 percent during
the 1952-1977 period and 1.1 percent and 7.0 percent during the 1978-2003
period, respectively11 . The amazing coincidence in the opening-up and the
take-o¤ implies that there might be a common source of these two. In thispaper, however, we do not explore the sources of aggregate TFP growth.
Instead, we deduce the quantitative impacts of a sudden growth in technology
on the Chinese and the ROW economies.
10

This gives 3.2% for the ROW and 3.75% for China. For convenience, we choose 3.5%
as the common depreciation rate.
11
The ROW series starts from 1955 due to the lack of employment data.

11

Figure 6. “Crude”Measure of TFP
7

6

5

4

3
1950

1955

1960

1965

1970

1975

1980

China

ROW

1985

1990

1995

2000

In short, the three key features of the Chinese economy are: (1) China
suddenly opened up in 1978, (2) output growth took o¤ in 1978 and (3)although the trade volume increased, there seems to be no trend in the
trade balance. We also show that a model that can successfully explain theimpact of China’s opening-up and growth must be able to account for thelack of consumption risk-sharing while incorporating a shock which manifests
itself as a gradual growth in aggregate total factor productivity. In thefollowing section, we consider a dynamic stochastic general equilibrium model
incorporating these features.

3

Backus, Kehoe and Kydland Economy

The basis of our model is a competitive market version of a two-country
two-good model à la Backus, Kehoe and Kydland (1994)12 . The two countries in the economy are China and the ROW. Intermediate goods produced
from capital and labor in each country are traded in the international goods
market. The terms of trade are de…ned as the relative price of the two. Labor and capital are internationally immobile. Final goods in each country
12

The competitive equilibrium setting follows Ra¤o (2006).

12

are produced from these intermediate goods. The countries can also tradestate-contingent international claims in a complete asset market. The model
is detrended with constant TFP growth in order to induce stationarity.

3.1

Households

We assume that representative households in both economies (i = C; R)
gain utility from consumption and leisure. The preference is a standard
Cobb-Douglas function for each household. The households maximize their
lifetime utility:
XtUi =( i log ci;t + (1li;t ))(1)i ) log(1tsubject to budget constraints:

wi;t li;t + ri;t ki;t + Ti;t + reri;t di;t = ci;t + xi;t + reri;t Qt di;t+1 :(2)

That is, the households receive income from labor li;t , capital ki;t , lumpsum transfer Ti;t 13 as well as the return from the claim di;t , and spend it on
consumption ci;t , investment xi;t and claims for the next period di;t+1 wherewi;t and ri;t are real wages and rental rates in domestic …nal goods units. The
price of international claims Qt is common to both countries14 . International
claims are denominated in the ROW currency, so claims holdings must be
adjusted for the real exchange rate rerC;t in China, whereas rerR;t = 1.
All prices are in real terms relative to the price level of …nal goods in eachcountry. We assume that the population growth rate n and the growth rateof technology on the world frontier are constant and de…ne = (1 + )(1 +n) in order to adjust for the trend. Investment is de…ned by the capital
accumulation equation:ki;t+1 = (13.2

)ki;t + xi;t :(3)Intermediate Goods Firms

The representative intermediate goods …rms in each country specialize inproducing goods a and b respectively. The …rms produce intermediate goods
13
14

As mentioned below, there is lump-sum transfer only in China.
The model is deterministic and the international claim is a redundant asset.

13

from labor and capital using a constant returns to scale technology:1yi;t = exp(zi;t )ki;t li;t(4)where zi;t represents the production e¢ ciency of the intermediate goods …rm
which we refer to as “productivity”in order to distinguish it from aggregate
TFP. Intermediate goods …rms maximize pro…ts:maxjt = pi;t yi;t

wi;t li;t

ri;t ki;twhere pji;t are the prices of intermediate goods (j = a; b) produced in eachcountry relative to the …nal goods prices in the corresponding country.

3.3

Final Goods Firms

The representative …nal goods …rms in each country produce …nal goods fromintermediate goods using Armington aggregation technologies:

GC;t (aC;t ; bC;t ; C;t ) =" 1"

C;t aC;t+ (1" 1

GR;t (aR;t ; bR;t ; R;t ) =(1"R;t )aR;t +" 1"

C;t )bC;t" 1"
R;t bR;t

"
" 1

(5)

"
" 1

:

where C;t and R;t are the weights of home goods.
As shown in the previous section, Chinese trade was roughly balanced
especially prior to the reform. For simplicity, we assume that the Chinese
government imposes tari¤s on foreign goods in order to maintain balanced
trade. Therefore, the pro…t maximization problem for the Chinese …nal goods…rm ismax GC;t (aC;t ; bC;t ; C;t ) paC;t aC;t (1 + C;t )pbC;t bC;t :where C;t is the tari¤ rate. On the other hand, we assume that the ROW
government does not impose tari¤s on its imports from China15 . Thus, thepro…t maximization problem for the ROW is
max GR;t (aR;t ; bR;t ; R;t )15

paR;t aR;t

pbR;t bR;t :In the appendix, we also provide for a model in which China also uses export subsidies
to promote trade.

14

3.4

Government

The Chinese government fully rebates the tari¤s with lump-sum transfers to
the households. Thus, the government budget constraint isaC;t pC;t bC;t = Tt :(6)

The ROW government plays no role in this model.

3.5

Resource Constraints

In any state of the economy, the resource constraints must hold in eachmarket. Resource constraints for intermediate goods are:aC;t +

1(7)

aROW;t = yC;t

and
bC;t + bROW;t = yROW;t(8)
1
where is the EAP weight of China among the total world population. The
resource constraints for …nal goods in each country are(9)ci;t + xi;t = Gi;t (ai;t ; bi;t ; i;t ):The market clearing condition for claims16
dC;t + (1)dROW;t = 0

GC;t ) + (1)rert (pbR;t yR;t

implies(paC;t yC;t

3.6

GR;t ) = 0:

PricesThe marginal utility of …nal goods consumption de…nes the price of …nal
goods in each country:
ucC;t = PC;tucR;t = PR;t :16

Since this is guaranteed by Walras’law, we do not include this in the set of equilibrium
conditions when we solve the model.

15

Therefore, in equilibrium, the real exchange rate can be expressed as follows:
rert =
Also, by de…nition,

paC;t
pbC;t
ucR;t
PR;t
= a = b =
:
PC;t
pR;t
ucC;t
pR;t
paC;t
paR;t
tott = b = b :
pC;t
pR;t

3.7

Exogenous Variables

3.7.1

Home Goods Weight

The home goods weight de…nes the shape of the …nal goods production possibility frontier, and thus determines the long-run share of home goods within
the Armington aggregator to produce …nal goods. We interpret the openingup and reform policy as a sudden reduction in Chinese home goods weightC;t . Since a reduction in home goods weight increases the demand for imports and stimulates exports by reducing the demand for home goods, thiscan explain the sudden increase in openness:
vt =

(1

)aR;t + bC;t =tottyt

in 1978.17
3.7.2

Productivity

Sources of TFP growth in China are discussed in studies such as Dekle andVandenbroucke (2006) and Young (2003). Unlike these studies, the main
purpose of our paper is not to reveal the source of TFP growth, but todeduce its impact on China and the ROW along with home goods weightshocks.
One accounting issue to be noted is that the intermediate goods …rm
productivity in our model is not equivalent to aggregate TFP introduced in
the previous section. In the GDP accounting sense, the value of production
17

We conjecture that a model with export tari¤s instead of variable home bias should
produce similar results to our model. We believe that the reform in China was more thana simple reduction in tari¤s but a shift in the social paradigm. Thus, changes in homebias seemed to be a better proxy of the reform and opening-up policy.

16

in country i is pji;t yi;t . Thus, aggregate TFP in each country is pji;t zi;t , whichjmeans that changes in both pji;t and zi;ta¤ect aggregate TFP. In the model,jj
we treat zi;t as exogenous and pi;t as endogenous.
3.7.3

Import Tari¤s

In the previous section, we showed that a key feature of the Chinese economy
is the stable trade balance. We consider import tari¤s as a key variable tomaintain balanced trade in China. We cannot directly use tari¤ data inthe quantitative section because of availability issues. Lardy (2002) reportedtari¤ data over the 1982-2001 period whereas we are interested in the period
before 1978. Lardy (2002) also stated that tari¤s did not have importante¤ects on imports since the government directly determined the quantities ofimports.
In this paper, we compute the tari¤s needed in order to guarantee balanced trade in the model. This way, we can compute the e¤ective tari¤ rate
which includes all ine¢ ciencies in the Chinese import goods market. One
criticism of our model could be that we do not incorporate …nancial market
disturbances such as limits on …nancial transactions and exchange rate control. However, we believe that a model with incomplete …nancial markets willproduce similar results to ours since our as-if tari¤s include these distortionsin the …nancial market18 .

3.8

Competitive Equilibrium

The competitive equilibrium is a set of allocations and prices for i = C; R;
1
ci;t ; li;t ; ki;t+1 ; yi;t ; xi;t ; Ti;t ; ai;t ; bi;t ; wi;t ; ri;t ; pai;t ; pbi;t ; zi;t ; i;t ; i;t t=0 such that,(1) households optimize given fwi;t ; ri;t ; Ti;t g1
t=0 and ki;0 , (2) intermediate1jgoods …rms optimize given wi;t ; ri;t ; pi;t ; zi;t t=0 , (3) …nal goods …rms opti1
mize given pai;t ; pbi;t ; i;t ; i;t t=0 , (4) markets clear, (5) the Chinese government budget constraint holds and (6) the resource constraints hold.
18
A one-to-one mapping is not possible since …nancial market imperfections will create awedge between the growth rate of marginal utility of consumption across countries, whiletari¤s create a wedge between the level of marginal utilities across countries.

17

4

Quantitative Analysis

4.1

Parameter Values

We assume the EAP weight to be constant at= 1=219 . The originalliterature solves the social planner’s problem so this parameter shows up
as Negishi Pareto weights. However, in the competitive market problem
we solve, this is simply the weights of EAP which show up in the resource
constraints of intermediate goods.
We set the shock persistence arbitrarily high so that the shock process
is almost unit root. The elasticity of substitution between home goods andforeign goods " is borrowed from Backus, Kehoe and Kydland (1994). The
capital depreciation rate is determined as mentioned. The discount factor
and the consumption-leisure parameter are calibrated to roughly matchdata for the steady state capital output ratio of 2:5 and the steady statelabor level of 0:320 .
For simplicity, we assume a symmetric steady state such that C = R =, aC = bR , aR = bC , tot = 1 and = 0. The steady state home goods weightis determined by the symmetric steady state terms of trade:
tot = 1 =

1

bC
aC

1
"

:

This depends on the steady state export to import ratio:
aC
1 bC =yC=
bC
bC =yC
where b=y is the steady state import share to production. Thus, the importshare determines the degree of home goods weight . We assume a steadystate import share of 0:15 following Backus, Kydland and Kehoe (1994),
which implies steady state openness equal to 0:3.
Table 1 presents the parameter values common to both countries.
19

In the data, this ranges from 0.58 to 0.64. For simplicity, we assume 0.5. Ra¤o (2006)
showed that the country size does not a¤ect the equilibrium allocation for a given export
share.
20
Steady state capital-output ratio of around 2:5 roughly matches the N-D data for bothcountries. Steady state labor level of around 0:3 implies a Frisch elasticity of labor supplyof 2:33 given log preferences, which is standard in the business cycle literature.

18

Table 1. Parameter Values
0.5
"
1.5
0.035
0.95
0.34
0.76
1/3

4.2

Simulation

In this section, we describe how we obtain nonlinear equilibrium paths ofendogenous variables given exogenous changes in home goods weight andproductivity over the 1950-2100 period. Since both home goods weight andproductivity are not directly observable, we choose them such that the endogenous Chinese GDP and openness roughly match the data. Speci…cally,
we assume that the openness and detrended GDP growth rate were 10% and
0% prior to 1978 and 30% and 5% after 1978. We set the post-1978 openness
constant at 30%, which is the value implied by the symmetric steady state insection 321 . In addition, we impose a balanced trade constraint throughout
the whole period.
Since the model is deterministic, the paths of exogenous variables are
perfectly foreseen. It does not seem reasonable to assume that the Chinese
agents knew that the opening-up and reform policy would occur in 1978 beforehand. Thus, we divide the period into two. The …rst period is illustrated
by low openness and GDP in China. The second period starts in 1978 inwhich suddenly openness and GDP growth rate increased. This setting implies that the agents were suddenly surprised by the new path of exogenous
variables and reoptimized in 197822 .
First, during the 1950-1977 period, we set the level of productivity suchthat Chinese GDP is roughly 5% relative to the ROW GDP. It turns outthat with this level of productivity, the symmetric steady state level of home
goods weight, C = 0:76, produces openness roughly equal to 10%23 . Next,
21

This is lower than the observed level in chapter 2, however, the openness in chapter 2
includes trade with countries other than the G7 countries.
22
This is the same setting as the sudden surprise exercise in Meza and Quintin (2007)
and Kehoe and Ruhl (2007).
23
It is well known that smaller countries have higher trade shares. Thus, this initial19

in 1978, we introduce a drop in home goods weight so that openness suddenly increases. Finally, we set paths for productivity growth and home
goods weight over the 1978-2100 period such that China’s openness remains
around the 30% level and detrended GDP grows roughly at the 5% level. We
extrapolate from 2004 assuming that China’s output continues to grow by
5% until it converges to the ROW level24 . This procedure is closely related tothe business cycle accounting method introduced by Chari, Kehoe and McGrattan (2007). They elicit exogenous wedges from equilibrium linearized
decision rules and data within a stochastic framework while we elicit exogenous variables from data and a deterministic system of equations, which is
the method they used in an earlier version of their paper.
Figure 7 shows the computed exogenous variables. Indeed, the home
goods weight suddenly drops as expected. Productivity initially jumps andthen gradually grows. In the following, we simulate the model with eachshock separately in order to analyze the e¤ects of each shock, and thendiscuss the overall e¤ect of both shocks. For all simulations, we assume thatbalanced trade holds throughout all periods.
home bias level should be considered high given China’s degree of development prior tothe opening.
24
Changing the speed of convergence does not a¤ect the result. We can alternatively
use a smoother path of convergence for the 2004-2100 period.

20

Figure 7. Exogenous Variables
0.8

0.5

0.7
0

-0.5
0.5
0.4

-1

Productivity

Home Goods Weight

0.6

0.3
-1.5
0.2
-2
0.1
0
-2.5
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100
Home Goods Weight

4.2.1

Productivity

Simulation with Home Goods Weight Shocks

Figure 8 presents the results of simulating the model with home goods weightshocks keeping productivity constant at its initial level while maintaining thebalanced trade constraint. All growing variables are expressed as log deviations from their long-run steady states while home goods weight, openness
and labor are expressed as levels.

21

Figure 8. Simulation Results with Home Goods Weight Shocks

The sudden reduction in China’s home goods weight causes a fall in theworld relative demand for good a. Since the demand for home goods falls,
China will produce less. Thus, in China both labor and investment fall andcapital stock falls following the drop in investment. Consumption initially
increases since the trade account remains balanced while investment falls
more than output does. Consumption gradually falls following the decline
in capital stock. As the home goods weight returns to the steady state,both labor and capital stock return to the steady state. As a result, China’s
utility is higher in the short run and becomes slightly lower in the medium run
relative to the initial level. As the home goods weight returns to the initiallevel, the economy goes back to the initial level. Tari¤s are high throughout
the period since productivity remains low. Since Chinese agents are bettero¤ running a trade de…cit while their income is below the steady state, thegovernment has to impose high tari¤s to prevent it.
In the ROW, since the world relative demand for b increases, this is apositive shock for production. The ROW will increase labor and investment
in order to produce more. Also, the instantaneous improvement in the termsof trade causes a positive income e¤ect in the short run. Thus, consumption
increases. Since consumption and labor both increase, the total e¤ect on22

utility is ambiguous. Nonetheless, the e¤ect of this shock is small in the
ROW since the country size of China relative to the ROW is very small.
4.2.2

Simulation with Productivity Shocks

Figure 9 shows the results of simulating the model with only productivity
shocks keeping the home goods weight constant at its initial level while maintaining the balanced trade constraint.
Figure 9. Simulation Results with Productivity Shocks

As in a standard neoclassical optimal growth model, a long-run increase inproductivity causes China’s output, investment and consumption to increase.
China’s labor grows and ends up at the steady state level since the pricedistortion vanishes in the long run as productivity approaches the steadystate level. China’s utility constantly grows as productivity increases, which
implies that the e¤ect of the increase in consumption outweighs the e¤ect of
the increase in labor on welfare.
Though China’s productivity growth does not have spill-over e¤ects on
ROW productivity, the ROW is a¤ected through the terms of trade e¤ect.
As China’s productivity increases, the relative price of good a falls, which is23

a positive terms of trade shock from the ROW perspective since the ROW’s
products are more valuable and foreign products are more a¤ordable. The
ROW produces more and consumes more so consumption and labor bothincrease. The e¤ect is signi…cant since as productivity grows the size of
China also grows, which leads to a signi…cant increase in trade and thus thebene…ts from it.
4.2.3

Simulation with Home Goods Weight and Productivity Shocks

Figure 10 shows the results of simulating the model with both shocks while
maintaining the balanced trade constraint. The results can be considered as
a combination of the two previous results25 .
Figure 10. Simulation Results with Both Shocks

Regarding the discrepancy of the model prediction and the data, somevariables such as investment, labor and consumption in China directly inherit
the jumps in home goods weight and productivity shocks in 1978. Investment
25

The results are not simple sums of the previous two counter-factual exercises since themodel is solved with a non-linear method and the previous simulations assumed balanced
trade in each case, which implies di¤erent tari¤s for each simulation.

24

and labor adjustment costs and habit formation in consumption might be asensible way to account for this discrepancy. Also, the model predicts a
gradual growth in detrended output, consumption and investment in the
ROW, which did not occur in reality. In the simulation we set the ROW
productivity constant. If the ROW productivity slightly fell, this would
counter the positive e¤ect of China’s productivity growth26 . We do not adjust
for these issues in order to make our model as simple as possible.
4.2.4

Welfare Analysis

In order to further assess the e¤ect of each shock on consumers’welfare, we
compute the welfare improvement in each country given the shocks in Table
2. Welfare improvement is de…ned as the present value of the di¤erence
between the periodical utility and the initial utility level summed over the
1978-2100 period. The column titles C , zC , C &zC stand for simulations
with only home goods weight shocks, with only productivity shocks and withboth shocks.
Table 2. Welfare Analysis
zC
C
C &zC
China 0.95 9.52
8.31
0.82
ROW 0.03 0.84
It turns out that China is better o¤ with only home goods weight shocks,
which implies that the short-run e¤ect of labor decline dominates the mediumrun e¤ect of consumption decline. On the other hand, the impact of China’s
home goods weight shocks on the ROW is very small. Both China and the
ROW are better o¤ due to the growth in Chinese productivity. The overalle¤ect is that both China and the ROW are better o¤ due to the opening-up
and growth of China.

4.3

Simulation without the Trade Balance Constraint

In this section we consider a case in which the Chinese government does not
impose a balanced trade constraint after the opening-up. In other words,
we remove tari¤s instantaneously in 1978 while allowing the trade balance
26

Indeed, the crude TFP measure is decreasing in the ROW. This suggests that productivity in the ROW may have been falling recently.

25

to ‡uctuate afterwards. For this counter-factual exercise, we use the same
initial states and the same shock levels assuming that trade was balanced
until 1977.
Common to all cases, removal of the trade balance constraint in 1978 has
a signi…cant e¤ect on welfare. In China, removal of the tari¤s leads them toimport more goods produced in the ROW and use less of their own products.
As a result, they work less and consume more, which makes them better o¤.
On the other hand, since the world demand for good b suddenly increases,
labor and investment increase in the ROW. Since the resources are used
in investment, the ROW can consume less in the short run. Therefore the
ROW is actually worse o¤ due to the removal of trade barriers. The following
simulation results can be considered as combinations of the original results
and the above-mentioned e¤ects of removing the balanced trade constraint.
4.3.1

Simulation with Home Goods Weight Shocks

Figure 11 shows the simulation results with home goods weight shocks keeping productivity constant at the initial level.
Figure 11. Simulation Results with Home Goods Weight Shocks ( = 0)26

The results show that China would have been better o¤ while the ROW
would have been worse o¤ as a result of China’s home goods weight decline
under free trade. As in the benchmark case, Chinese agents work less dueto the drop in home goods demand. In addition, since China borrows fromabroad running a trade de…cit, they can consume more. Thus, China is evenmore better o¤ than in the benchmark case. On the other hand, the ROW
works more since the demand for good b increases. Also, since they lend to
China, they consume less. Hence, the ROW is worse o¤.
4.3.2

Simulation with Productivity Shocks

Figure 12 shows the simulation results with productivity shocks keeping thehome goods weight constant at the initial level.
Figure 12. Simulation Results with Productivity Shocks ( = 0)

The results show that China is better o¤ for sure as a result of productivity
growth. Once the balanced trade constraint is relaxed, China borrows fromthe ROW running a trade de…cit and increases consumption. At the sametime, the Chinese work more due to the increase in productivity. It turns
out that the periodical utility increases for all periods. On the other hand,27the sudden drop of tari¤s makes the ROW worse o¤ temporarily. In the longrun, the steady state consumption in the ROW is higher than that in theinitial state. Thus, the e¤ect on ROW welfare is ambiguous.
4.3.3

Simulation with Home Goods Weight and Productivity Shocks

Figure 13 shows the results of the simulation with both shocks.
Figure 13. Simulation Results with Both Shocks ( = 0)

From the previous two results, we know that China is unambiguously
better o¤. On the other hand, in the ROW periodical utility initially falls dueto the removal of trade restrictions and the decline in Chinese home goods
weight, and then grows due to the terms of trade e¤ect from the Chinese
productivity growth so the total e¤ect of the shocks is ambiguous. In orderto quantify the e¤ects, we conduct a welfare analysis as in the benchmark
case.
4.3.4

Welfare Analysis

Table 3 shows the results of the welfare analysis.
28

Table 3. Welfare AnalysiszCCC ; zC
China 12.29 11.29 14.94
ROW -3.72 -0.21 -1.92
The results indicate that while China is better o¤, the ROW is worse o¤after home goods weight and productivity shocks. It is surprising that the
ROW is worse o¤ even with only the productivity growth in China. Although
the ROW will reach a higher level of output, capital, consumption and so on,
the short-run loss is so high that overall it is worse o¤. In addition, the total
world welfare is higher than in the case when there is the balanced trade
constraint. This counter-factual exercise shows that the Chinese balanced
trade policy was actually welfare improving from the ROW’s point of view
and welfare deteriorating from China’s.
The result that the balanced trade policy makes the ROW better o¤
is interesting since today the ROW seems more supportive of Chinese free
trade than China is. Also, from China’s point of view, it is puzzling why
they did not engage in free trade by which they would have been better o¤.
One possible explanation is that China protected its domestic industry frominternational competition to buy some time to adopt foreign technology. Thiskind of infant industry protection policy may be key to explain also the TFP
growth.

5Conclusion

In this paper, we assessed the global impact of China’s opening-up andgrowth within a standard neoclassical two-country two-good framework. We
showed that a sudden drop in home goods weight and gradual productivity growth in China can account for the sudden increase in openness andrapid output growth in China. We found that the home goods weight shock
per se is welfare improving for China while its impact on the ROW is small.
We also found that productivity shocks are welfare improving for both China
and the ROW. Thus, we conclude that China’s reform and opening-up policy
was welfare improving for both economies if it led to signi…cant productivity
growth. We also showed that the China’s balanced trade policy helped theROW rather than China.
Since we focused on the impact of shocks on China and the ROW, we
did not model the source of productivity growth and took it as exogenous.
29

Future study should aim to reveal the relationship between the opening-up
and productivity growth in China. One way to model this relationship is
to assume that opening-up removed the technological barrier between the
ROW and China, and led to gradual TFP growth in China as in Parente andPrescott (1994) and Eaton and Kortum (1997). Alternatively, if the import
goods from abroad convey cutting-edge technology, the increase in imports
itself causes productivity growth. In any case, we consider our model as afoundation to understand the impact of Chinese growth.
Our conclusion that China’s balanced trade policy was helping the ROW
is somewhat controversial considering the political debate on Chinese free
trade. China’s exchange rate policy has been accused mainly by the US since
the undervalued RMB allegedly widened its trade de…cit with China and thus
caused job losses in manufacturing. However, in our model, devaluing the
RMB is like removing tari¤s from the Chinese point of view, which would
make the ROW worse o¤ since more working brings more disutility. In order
to incorporate the cost of job losses, we can add job search structure or
simply introduce heterogeneity in worker and non-worker preferences.
Finally, stochastic simulations may have di¤erent quantitative implications from our results. In our deterministic settings, Chinese agents correctlypredict the steady state and the rapid growth path after 1978, which givesa large incentive for Chinese agents to run a trade de…cit. In a stochastic
setting, this income e¤ect may not be so large. However, we believe that thequalitative results should not di¤er.

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32

A

Export Subsidy Model

Instead of home goods weight shocks, we can model shocks to China’s subsidies on its exports as the driving force of sudden changes in trade volume. The modi…cation is straightforward such that now besides levying tari¤
on imports, the Chinese government gives subsidies sC;t to foreign exports.
Hence, the …nal goods …rms’problem in the ROW is
max GROW;t (aROW;t ; bROW;t )(1

sC;t )paROW;t aROW;t

pbROW;t bROW;t :Also, the government budget constraint changes accordingly toaaC;t pC;t bC;t + sC;t pROW;t aROW;t = Tt :China’s subsidies and tari¤s are at levels such that trade is virtually balanced and openness is at the pre-opening level. Once China opens up to theinternational market, tari¤s dramatically decline, which increases the tradevolume, and subsidies adjust accordingly such that trade remains balanced.
Qualitatively speaking, this model can generate similar results to those fromthe model with home goods weight shocks. However, quantitatively speaking,we found it di¢ cult to replicate patterns of openness and the trade balancewith export subsidies and tari¤s.

33