Trade with Nominal Rigidities: Understanding the Unemployment and Welfare Effects
What this paper finds — and why it matters
Standard international trade models assume perfectly flexible prices and full employment. This paper introduces nominal rigidities (downward wage rigidity) into a quantitative trade model and asks how this changes the welfare gains from trade liberalization. The central finding is that standard flexible-price estimates overstate the welfare gains by approximately one-third: trade liberalization can generate unemployment in import-competing sectors when wages cannot fall, and the forgone output from these workers is a welfare cost that flexible-price models miss entirely. The paper calibrates the degree of downward wage rigidity to cross-country data on unemployment volatility and shows that the magnitude of the overstatement is robust across a range of calibrations. An analytical decomposition separates the allocative efficiency gains (which standard models capture) from the employment losses (which they miss), clarifying when the overstatement is large versus small.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. How does downward wage rigidity create unemployment from trade liberalization?
When import competition reduces demand for domestic labor in an affected sector, wages cannot fall fast enough to clear the labor market under downward rigidity; workers are priced out of re-employment in the short run, generating cyclical unemployment in the import-competing sector that persists until real wages adjust through inflation erosion. The unemployment is involuntary and represents forgone production — a social cost that flexible-price models attribute to zero by assumption.
Q2. Why is the overstatement approximately one-third?
The one-third figure comes from the ratio of the employment-loss welfare cost to the total flexible-price welfare gain in the paper’s benchmark calibration; the rigidity-driven employment loss is large enough relative to the allocative efficiency gain to reduce net welfare gains substantially, but not so large as to eliminate them. This ratio is not universal — it depends on the degree of wage rigidity, the sectoral composition of trade exposure, and the speed of labor reallocation — but the paper shows it is robust across plausible parameter ranges.
Q3. Does trade liberalization still generate net welfare gains?
Yes, on net the welfare gains from trade remain positive even with downward wage rigidity — the overstatement of one-third means the true gains are positive but smaller than flexible-price models predict, not negative. The paper does not argue against trade liberalization but against using flexible-price welfare estimates without adjustment for unemployment costs.
Key concepts
downward wage rigidity : the empirical constraint that nominal wages adjust slowly downward; the key friction this paper adds to the quantitative trade model, generating unemployment in sectors hit by import competition.
welfare overstatement : the gap between the flexible-price welfare gain from trade liberalization (the standard model’s prediction) and the true gain once unemployment costs from nominal rigidity are accounted for; approximately one-third in the paper’s benchmark calibration.