Oleg Itskhoki

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This paper develops a new framework for examining the distributional consequences of international trade that incorporates firm and worker heterogeneity, search and matching frictions in the labor market, and screening of workers by firms. Larger firms pay higher wages and exporters pay higher wages than non-exporters. The opening of trade enhances wage inequality and raises unemployment, but expected welfare gains are ensured if workers are risk neutral. And while wage inequality is larger in a trade equilibrium than in autarky, reductions of trade impediments can either raise or reduce wage inequality.

Conventional wisdom suggests that the optimal policy response to rising income inequality is greater redistribution via higher marginal tax rates and more progressive tax schedules. In this paper we study an economy in which trade is associated with a costly entry into the foreign market, so that only the most productive agents can profitably participate in foreign trade. In this model, trade integration simultaneously leads to rising income inequality and a more sensitive efficiency margin of taxation, both driven by the extensive margin of trade. As a result, the optimal policy response may be to reduce the marginal taxes, thereby further increasing inequality. In order to reap most of the welfare gains from trade, countries may need to accept increasing income inequality.

In this paper we develop a multi-sector general equilibrium model of firm heterogeneity, worker heterogeneity and labor market frictions. We characterize the distributions of employment, unemployment, wages and income within and between sectors as a function of structural parameters. We find that greater firm heterogeneity increases unemployment, wage inequality and income inequality, whereas greater worker heterogeneity has ambiguous effects. We also find that labor market frictions have non-monotonic effects on aggregate unemployment and inequality through within- and between-sector components. Finally, high-ability workers have the lowest unemployment rates but the greatest wage inequality, and income inequality is lowest for intermediate ability. Although these results are interesting in their own right, the main contribution of the paper is in providing a framework for analyzing these types of issues.

In this paper I show, for a general class of models with limited commitment, that an economy is able to effectively buy a commitment technology by accumulating assets that can be seized by its counterparts in case if the economy deviates from the originally prescribed action plan. In fact, this strategy is optimal if the economy is patient enough, i.e. β(1 + r)≥1, and the welfare costs of this strategy compared to the first best are very low. As a result, many of the models, the central feature of which is limited commitment in some form, do not deliver interesting results in the long-run, as the problem of the lack of commitment is entirely resolved by optimal asset accumulation. It is not the case, however, if the economy is impatient, i.e. β(1 + r)<1, or along the transition path with the growth rates higher than in the long-run. In case of impatience, the limited commitment problem is never resolved fully even in the long-run. The main focus of the paper are small open economy models with endogenously incomplete markets and other frictions.

We study a two-country two-sector model of international trade in which one sector produces homogeneous products and the other produces differentiated products. Both sectors are subjected to search and matching frictions in the labor market and wage bargaining. As a result, some of the workers searching for jobs end up being unemployed. Countries are similar except for frictions in their labor markets, such as efficiency of matching and costs of posting vacancies, which can vary across the sectors. The differentiated-product industry has firm heterogeneity and monopolistic competition. We study the interaction of labor market rigidities and trade impediments in shaping welfare, trade flows, productivity, and unemployment. We show that both countries gain from trade. A country with relatively lower frictions in the differentiated-product industry exports differentiated products on net. A country benefits from lowering frictions in its differentiate sector’s labor market, but this harms the country’s trade partner. Alternatively, a simultaneous proportional lowering of labor market frictions in the differentiated sectors of both countries benefits both of them. The opening to trade raises a country’s rate of unemployment if its relative labor market frictions in the differentiated sector are low, and it reduces the rate of unemployment if its relative labor market frictions in the differentiated sector are high. Cross-country differences in rates of unemployment exhibit rich patterns. In particular, lower labor market frictions do not ensure lower unemployment, and unemployment and welfare can both rise in response to falling labor market frictions and falling trade costs.

We empirically document using U.S. import prices that on average goods with a high frequency of price adjustment have a long-run pass-through that is at least twice as high as that of low-frequency adjusters. We show theoretically that this relationship should follow because variable mark-ups that reduce long-run pass-through also reduces the curvature of the profit function when expressed as a function of the cost shocks, making the firm less willing to adjust its price. Lastly, we quantitatively evaluate a dynamic menu-cost model and show that the variable mark-up channel can generate significant variation in frequency, equivalent to 37% of the observed variation in the data. On the other hand the standard workhorse model with constant elasticity of demand and Calvo or state-dependent pricing has difficulty matching the facts.

In the open economy macro literature with nominal rigidities, the currency in which goods are priced has important implications for optimal monetary and exchange rate policy and for exchange rate pass-through. We show, using novel data on currency and prices for U.S. imports, that even conditional on a price change, there is a large difference in the pass-through of the average good priced in dollars (25%) versus non-dollars (95%). We document this to be the case across countries and within disaggregated sectors. This finding contradicts the assumption in an important class of models that the currency of pricing is exogenous. We present a model of endogenous currency choice in a dynamic price setting environment and show that the predictions of the model are strongly supported by the data.

In this essay we postulate a number of theoretical hypotheses allowing one to resolve in some degree the following two prediction paradoxes: (1) why simple linear models often have an advantage in predictive power over more complex nonlinear models that lead to a better in-sample fit; (2) why combinations of forecasts often increase the predictive power of individual forecasts. We also give a numerical example illustrating our theoretical statements.