The impact of trade policy and exchange rate shocks on trade volumes and prices in post-Brexit Britain

How will Brexit affect the development and growth of British manufacturing firms? Britain's popular referendum vote to exit from the European Union has created a great deal of uncertainty about the future of Britain's external trade relations with countries that belong to the European Union as well as with other major trading economies external to the EU, including the United States and China. With the government preparing for exit negotiations, little is known about the future external trade policy the UK government intends to establish with regard to European Union states as well as with non-EU countries.

Theresa May's announcement of her intention to withdraw Britain from the single market implies that Britain will be confronted with the task of conducting its trade policy independent of the EU. The imminent de-coupling of Britain's external trade policy from that of the EU raises a host of questions about the appropriate conduct of both trade and monetary policy to serve the needs of manufacturers located in Britain and the British population. For example, the EU (inclusive of Britain) currently has in place import restrictions on products that constitute roughly 7 percent of China's exports to the EU (Bown and Crowley, 2016). When Britain formally leaves the EU, the import protection afforded by these restrictions will disappear and Britain will have to decide whether it wants to re-institute new tariffs on these goods or go forward with a freer trade policy. Key to making a sound policy choice will be an understanding of the consequences of not only any tariff imposed by Britain, but also how the existence of the EU tariff will impact Britain's trade and domestic import-competing manufacturers who have been battered by intense global competition.

Other practical and pertinent questions raised by Brexit include: How much will the price of Britain's imports rise as a consequence of the pound's devaluation? How will the volume of its exports change when the relative price of its imported inputs increases and the relative price of its exports fall on world markets? Which industrial sectors will benefit the most from the competitive advantage in foreign markets arising from the pound's devaluation? How will a new EU or US import tariff on Chinese steel affect British steel manufacturers?

In order to predict the impacts of trade policy and exchange rate movements on important variables like import prices and export volumes, economic models need as inputs crucial parameters like the responsiveness (elasticity) of import prices to exchange rate movements and the responsiveness (elasticity) of British imports to changes in trade policy around the globe. How to identify and estimate these crucial parameters is an open research question in economics.

The proposed project will address these challenges by developing economic models and estimating the key parameters of these models in order to answer these questions. To achieve this, we will develop the implications of Corsetti and Dedola (2005) and Bown and Crowley (2007), will build upon the existing methodologies in Bown and Crowley (2006, 2007) and Crowley, Song and Meng (2016), will build new and unique datasets, and will develop novel methodologies where necessary to inform, in a timely fashion, new questions that are raised by Brexit.

The proposed research would result in cutting edge, timely economic analysis and forecasts. We will proactively engage with key stakeholders of this research in a targeted and timely way, namely (1) civil servants who will need to support the design, conduct and implementation of trade and monetary policy, (2) policy makers who must decide on the design of these two areas of policy, and (3) manufacturing firms and (4) manufacturing sector workers who will be impacted by the consequences of these policy choices.

Presently, Britain's civil service will be challenged to design, analyze, negotiate, and implement trade policy for exports and imports valued at £287 billion and £407 billion, respectively, in 2015. Britain faces a tremendous challenge in developing the institutional capacity necessary to manage this enormous and complex task. In the United States, trade policy functions are conducted by a number of government departments including the Department of Commerce, the Office of the US Trade Representative and the US International Trade Commission (USITC). The USITC alone has a permanent staff of hundreds including lawyers and administrative judges with specialist knowledge of international trade law and PhD economists who conduct the sophisticated statistical analyses required to determine if import restrictions can be put in place. In contrast, Britain's Department for International Trade was created in the autumn of 2016 with Civil Service World reporting in September that efforts were underway to recruit 25 high-level analysts to manage a large portfolio of trade policy functions. By providing concrete policy analysis and offering research tools for future analysis, the proposed project could have an important and significant impact on British society.

The proposed research will provide answers to a number of questions including: How much will the price of Britain's imports rise as a consequence of the pound's devaluation? How will the volume of its exports change when the relative price of its imported inputs increase? Which industrial sectors will benefit the most from the competitive advantage in foreign markets arising from the pound's devaluation? How will a new EU or US import tariff on Chinese steel affect British steel manufacturers?

The direct beneficiaries of this research are therefore the (1) policymakers and (2) civil servants responsible for designing, analyzing, negotiating and implementing trade and monetary policy for Britain when it separates its trade policy from the EU, especially those in the Treasury, the Department for Business, Energy and Industrial Strategy (BEIS), the Bank of England (BOE), the Foreign Office including the teams around Secretaries of State for Exiting the EU and for International Trade, as well as (3) MPs in Parliament who will be concerned with the implications of future trade and price scenarios for their constituents. Ultimately, the beneficiaries are (4) the firms, (5) workers, and (6) consumers in Britain who will all benefit from a government that is attuned to consequences of a devalued pound for the distribution of prices in Britain and to the distributional impact of new trade policies.

To disseminate the implications of this research to key stakeholders, we propose to (1) draft four 1500 word policy articles on the policy implications of the academic research for submission to VoxEU.org, the Centre for Economic Policy Research's Policy Blog, (2) write non-technical policy discussion papers focused on important questions of interest to policy makers, (3) host three policy workshops with the assistance of Cambridge's Centre for Science and Policy (CSaP) targeting 20 policy professionals including economists at the Bank of England and economists, lawyers and trade negotiators at the newly forming Department of International Trade, (4) organize an academic research conference that culminates with a policy roundtable discussion that is open to the public, and (5) present the research outputs at high-profile academic conferences.

In the short run, the proposed policy documents and workshops would aid policymakers by providing answers to questions to government institutions which have yet to develop internal capacity for analysis. In the medium to long run, the models of economic analysis in our research agenda could be adopted and implemented internally by these institutions to guide future policy decisions.