No. 924 - Trade elasticity and vertical specialisation

This paper shows that vertical specialisation can increase the elasticity of trade to income, hence explaining dramatic events such as the great trade collapse. We argue that a change in the extent of vertical specialisation affects the elasticity of trade to income, while a mere change in global production levels for a given extent of vertical specialisation does not. In the model we show that only large demand shocks induce firms to vary the extent of vertical specialisation. Using panel data starting from the late 1990s that include the 2008-09 global crisis, we consistently find that the correlation between trade elasticity and vertical specialisation increases precisely in years of large demand shocks, such as the ICT euphoria and the great trade collapse.