Trade and long term unemployment

What is the effect of international trade on unemployment? In this paper,[1] we explore the link between openness to trade and unemployment using a multi-country, multi-sector gravity model with embedded heterogeneous sector-and-country specific labour market frictions. Specifically, we introduce Diamond-Mortensen-Pissarides search-and-matching frictions, as modelled in Helpman and Itskhoki (2010),[2] into a Ricardian trade model a-la Eaton and Kortum (2002).[3] The resulting equilibrium allows for long-term unemployment levels, as search-and-matching frictions prevent all workers from getting employed. Key contribution of our approach is that it allows for general equilibrium effects from multiple trading partners, which would otherwise be disregarded in a two-country setting.

The model predicts that trade liberalisation may lead to an increase in unemployment if it results in labour reallocation into sectors with higher-than-average labour market frictions. How labour is reallocated across sectors (including non-tradable) following a trade reform depends on both the exporter's comparative advantage and the general equilibrium effect from the changes in world-wide wages, which adjust to the new trading structure. In cases where the general equilibrium effect is minimal, countries with a comparative advantage in friction-intense sectors experience a rise in unemployment, even when their welfare is increased.

The strength of the model is its ability to capture a wide range of effects, while most of the required data such as trade flows is readily observable. Sector-and-country specific frictions are estimated using panel data on an equilibrium unemployment identity derived from the model. The calibrated model is used to explore employment and welfare variations in a set of counter-factual exercises, and in particular to compare the impact of the potential Transatlantic Trade and Investment Partnership (TTIP) employment rates of US and EU countries, but also of other OCDE countries outside the TTIP.

Implications of this multi-country, multi-sector general equilibrium model of trade and equilibrium unemployment are several. Most importantly, we show that welfare and long-term unemployment are closely but not exactly related. Both the distinctions and the similarities between the two criteria are important. Any reform that raises aggregate demand boosts job creation, which raises wages and reduces unemployment. However, trade reforms also reallocate resources and labour across sectors, and insofar as sectors have heterogeneous labour market frictions, this reallocation also has an impact on a country’s unemployment rate. We show that, overall, trade can therefore be both employment augmenting and reducing, and the direction of this total effect depends on the relative strength of labour market frictions in the expanding sectors.

  1. Carrere, Céline; Grujovic, Anja and Frédéric Robert-Nicoud, 2014. “Trade and long term unemployment: A quantitative assessment." forthcoming. ↩︎

  2. Helpman, Elhanan and Oleg Itskhoki, 2010. “Labor Market Rigidities, Trade and Unemployment”. Review of Economic Studies 77 (3), 1100-1137. ↩︎

  3. Eaton, Jonathan and Samuel Kortum, 2002. “Technology, Geography and Trade.” Econometrica, 70: 1741–1780. ↩︎