Trade with nominal rigidity: Understanding the impact of China’s push on unemployment and welfare
Andres Rodriguez-Claire, Mauricio Ulate, Jose P. Vasquez 17 May 2022
Concerns about international trade have grown, as recent research has documented the negative impact of Chinese import competition on the US labor market. This column provides a new framework for interpreting this observation, which relies on the presence of declining nominal wage inflexibility in the US labor market. Increased competition from China improves U.S. trade conditions, but nominal wage conflicts prevent the labor market from adjusting, reducing both employment and labor force participation in the short term. Welfare effects vary significantly across states, but favorable terms of trade have a positive overall effect.
Concerns about international trade are often raised by the public and popular press that it could destroy jobs and lead to unemployment. In light of the growing evidence among high-income countries, the debate over the potential benefits of trade has become increasingly important. The effects of this labor market are particularly significant in areas where employment is relatively more dependent on productivity, as companies in this sector have become less competitive against their Chinese rivals (Dorn & Level 2022, Grossman and Overfield 2022).
In the United States, influential paper by Autor et al. (2013) show that increased competition from imports from China (also referred to as ‘China shock’) has led to a relative increase in unemployment and a decrease in labor force participation in commuting zones that are more exposed to China shock than in less open areas. . These relative effects are difficult to square with the predictions of standard trade models that do not feature unemployment. They suggest the presence of friction that prevents the labor market from adjusting immediately after the trade push.
To understand the effects of trade on the labor market, we present a model that allows us to quantify the overall impact of a trade push in line with the empirical data uncovered by Autor et al. (2013) (Rodríguez-Clare et al. 2022). The key feature of this model is the inflexibility of downward nominal wages, limiting nominal wages to no less than a certain percentage per year, and creating unintended unemployment whenever the limitation is mandatory. We have embedded this feature in a dynamic trade and transfer model in the consciousness of Calindo et al. (2019), which we are expanding to differentiate between the elasticity that controls the mobility of workers across the sector and the elasticity that controls their mobility across the local labor market. It is important to allow for these different resiliences to match the empirical evidence of Autor et al. (2013). These resiliences are the key parameters of the model, with the degree of nominal wage inflexibility going down.
We need to introduce a nominal anchor for the presence of declining nominal wage inflexibility which prevents nominal wages from increasing so much in each period that the constraint is always non-binding. We have chosen a general nominal rule that seeks to capture the notion that central banks are unwilling to allow inflation to be too high (due to its associated costs) at the same time appropriate to quantify our trade setting. In particular, we assume that the world’s nominal GDP in dollars grows at a constant and outward rate (which we set to zero without the loss of generality). Then, as is common in the literature, we consider the China shock to be an improvement in productivity in China that varies across different sectors and over the years. We match these productivity changes and the parameters of the original model with the changes in US imports from China that we observe in the data (when changes in imports from China to other rich countries are estimated) as well as regression results from Autor et al. (2013) How labor participation, unemployment, and population across the U.S. labor market are affected by China’s push. This calibration leads to a degree of declining nominal wage inflexibility, which means that with uninterrupted world nominal GDP, wages can be reduced by up to 2% per annum without being mandatory. This value is similar to Schmitt-Grohe and Uribe (2016).
Equipped with a calibrated version of our model, we simulate the effects of China Shock for the period 2000-2007 using dynamic accurate hat algebra, so that we do not need to explicitly calibrate sector-level trade costs and productivity levels in our initial year. . We see that the declining nominal wage inflexibility has a critical qualitative and quantitative effect on how the US states adapt to China’s push. In particular, we see that although China’s push improves trade conditions for all but one state in the United States, employment actually falls in most states at times of change, both due to rising unemployment and declining labor force participation. This means that declining nominal wage inflexibility is not only expanding the terms of trade, but it can also reverse those effects. For example, a favorable terms of trade for labor market adjustment that would require substantial nominal wage reductions would activate nominal wage constraints and create unemployment, which would be detrimental to the economy.
Intuitively, in a world with flexible wages, China’s relative productivity growth requires a downward adjustment in US relative wages. The declining nominal wage inflexibility prevents this adjustment from occurring with a large fall in U.S. nominal wages, and the nominal anchor prevents this from occurring through a large increase in Chinese dollar wages. The result is temporary unemployment in the United States. Instead, this unemployment triggers a further decline in labor participation, as more workers choose to opt out of the labor market rather than face the possibility of becoming unemployed. Our Model Quantification shows that China Shock lost about half a million jobs in the United States between 2000 and 2007. However, as the impact of unemployment reverses over time as nominal wages decline, employment eventually increases after the economy has fully adjusted. Positive conditions for long-term trade.
The spatial variation in the impact of China shock employment and income implied by our model is similar to that implied by the empirical results of Autor et al. (2013). This is in stark contrast to previous quantitative trade models, such as Calindo et al. (2019) and Galle et al. (2022), which provides very low scattering, as shown in Adao et al. (2020) and Autor et al. (2021). The main reason we get a high dispersion is that, due to the inflexibility of lower nominal wages, our model leads to a much larger decline in employment in the most open areas, both through high unemployment and indirectly discouraging labor participation.
One of the advantages of having a simple balance model structure is that we can study the effects of China shock on welfare. We find a negative correlation between welfare change and import exposure in China (see Figure 1). On the one hand, we see that imports from China reduce state-level welfare by an additional $ 1,000 per worker eight basis points. On the other hand, we see that despite the spread of welfare effects across state-sector pairs (see Figure 2), welfare increases in most U.S. states, many of which experience unemployment during the transition. As a result, China’s shock is beneficial to the United States, even with declining nominal wage rigidity. However, lower nominal wage inflexibility has significant welfare effects, as it leads to a 25% reduction in U.S. profits from shocks (from 31 to 23 basis points) and absolute welfare losses in seven states that benefited from China’s shock. Otherwise
Figure 1 China shocks exposure to welfare change versus US state
Figure 2 Histogram of welfare change across different sector-states of the United States
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