This project continues ongoing theoretical research with Andrew Newman on the relation between capital markets, income distribution and the process of development. A class of theoretical models of trade and growth and income distribution are developed based on the premise that producers face imperfect credit markets. This premise is widely supported by the available data from developing countries. Moreover capital market imperfections are often cited as one important reason why liberal trade policies may not promote growth. Finally, capital market imperfections provide a natural basis for a dynamic theory of the personal distribution of wealth, and therefore this framework is particularly suited to analyze questions about the effect of liberalizing trade on inequality.

More specifically, this project develops a simple Ricardian model of a small open economy with a large number of goods, imperfect capital markets and price-taking behavior in all markets. There is one final good that is produced using all the other goods, which are intermediates. The final good is not traded but all investment and consumption take place in the final good. Capital is the only input used for production of the intermediate goods. The relative productivity of different goods varies across countries, which provides the basis for trade. In the first best, each country would only produce the good in which its relative productivity is the highest and import the rest. As the technology of production is linear and there are no non-reproducible inputs, the economy is capable of long-run growth. Agents are long-lived and have standard forward-looking preferences. They borrow and lend to each other, with the interest rate moving to clear the capital market. The capital market imperfection is modeled as stemming from ex post moral hazard (borrowers may try to avoid repaying loans). This is shown to generate a limit on the extent to which a borrower can be leveraged. Each agent in the economy is initially assumed to have a particular skill that associates him with the production of a particular commodity. In the closed economy all goods will be produced. The conjecture is that in the steady state all sectors will be equally profitable, so it is reasonable to assume that the population will be evenly spread out across the sectors.

If this economy is opened to foreign trade, the growth rate goes up on impact and continues to go up until the economy converges to its steady state growth path. At that point the economy should be completely specialized in the production of the good in which it has a comparative advantage. This slow transition is because the capital market imperfection limits the amount of capital that can flow into the most productive sector. The project examines the proposition that the increase in the growth rate that comes from opening the economy is always accompanied by an increase in inter-sectoral inequality and this increase will continue over a period. Unless the sectors that gain from trade were initially much poorer, this will translate into an increase in inequality of the personal distribution of wealth and consumption. It is worth emphasizing that in the first-best version of this economy, freeing trade would not increase inequality. This unambiguous result relies on the absence of labor inputs and other non-traded goods from the basic model. Once the model is extended to introduce some non-traded goods or make labor an input, the effect on inequality depends on the initial position of the workers and producers of the non-traded goods, relative to the producers of the traded goods that are no longer being produced. The effect on inequality will also be modified if people choose their occupations. If only newborns can switch professions, the dynamic process generated by the joint process of trade expansion and changes in the occupational distribution appears to be relatively tractable. Countries that have relatively good capital markets will follow a Kuznets (inverted-U) curve after being opened to trade, but countries with less good capital markets will follow an inverted-J curve (inequality will go up but will not come down in any reasonable time-scale).

This framework is also used to study the impact of trade expansion (due, say, to the WTO) on inter-country inequality. If multiple countries simultaneously become more open, inter-country inequality is likely to go up in the short run, because the richer countries tend to have better capital markets. Finally, the framework is applied to questions of optimal trade policy. Since in this framework the allocation of capital between sectors is not necessarily optimal at any point of time, government policy can affect the growth rate by accelerating or decelerating the process of reallocation of capital. The conjecture is that an import tariff will always slow down growth but an export subsidy may sometimes help to raise the growth rate. The difference stems from the fact that import tariffs favor inefficient sectors while the subsidy favors the strongest sectors in the economy. The project plans further examination of a broader set of policies.

National Science Foundation (NSF)
Division of Social and Economic Sciences (SES)
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Daniel H. Newlon
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Massachusetts Institute of Technology
United States
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