This paper reviews a new framework for analyzing the interrelationship between inequality, unemployment, labor market frictions, and foreign trade. This framework emphasizes firm heterogeneity and search and matching frictions in labor markets. It implies that the opening of trade may raise inequality and unemployment, but always raises welfare. Unilateral reductions in labor market frictions increase a country’s welfare, can raise or reduce its unemployment rate, yet always hurt the country’s trade partner. Unemployment benefits can alleviate the distortions in a country’s labor market in some cases but not in others, but they can never implement the constrained Pareto optimal allocation. We characterize the set of optimal policies, which require interventions in product and labor markets.

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Elhanan Helpman, Oleg Itskhoki and Stephen J. Redding

December 2010     Paper Number CEPDP1028

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This CEP discussion paper is published under the centre's Trade programme.