Understanding the Unemployment and Welfare Effects of the China Shock

Trade with Nominal Rigidities: Understanding the Unemployment and Welfare Effects of the China Shock

Andres Rodríguez-Clare, Mauricio Ulate, José P. Vasquez May 17, 2022

Concerns about international trade have grown as recent studies document a negative effect of competition from Chinese imports on US labor markets. This column provides a new framework to explain this observation, which relies on the presence of downward nominal wage rigidity in US labor markets. Increased competition from China improves US terms of trade, but nominal wage frictions prevent the labor market from adjusting, so employment and labor market participation fall in the short term . The welfare implications vary widely across states, but the favorable terms-of-trade shock leads to a positive overall effect.

Public opinion and the popular press often fear that international trade will destroy jobs and lead to unemployment. The debate over the potential gains from trade has become increasingly important in light of growing evidence in high-income countries of negative employment effects in labor markets that are relatively more exposed to competition from imports from low-income countries such as China. These labor market effects are particularly important in localities whose employment is relatively more dependent on manufacturing, since firms in this sector have become less competitive compared to their Chinese counterparts (Dorn and Levell 2022, Grossman and Oberfield 2022).

In the United States, the influential article by Autor et al. (2013) find that increased competition from imports from China (also called the “China shock”) led to a relative increase in unemployment and a decrease in labor force participation in commuting areas that were more exposed to the shock Chinese compared to those who were less exposed. . These relative effects are difficult to reconcile with the predictions of standard business models that do not take unemployment into account. They suggest the presence of frictions that prevent the labor market from adjusting immediately after a trade shock.

To understand the effects of trade on the labor market, we present a model that allows us to quantify the aggregate implications of trade shocks while being consistent with the empirical facts discovered by Autor et al. (2013) (Rodríguez-Clare et al. 2022). The main characteristic of this model is the downward rigidity of nominal wages, constraining the nominal wage not to decrease by more than a certain percentage per year and generating involuntary unemployment whenever the constraint is binding. We integrate this characteristic into a dynamic model of trade and migration in the spirit of Caliendo et al. (2019), which we extend further to allow for a difference between the elasticity governing workers’ mobility between sectors and the elasticity governing their mobility between local labor markets. Accounting for these different elasticities is crucial to matching the empirical evidence of Autor et al. (2013). These elasticities, together with the degree of downward rigidity of nominal wages, are the key parameters of the model.

The presence of downward nominal wage rigidity forces us to introduce a nominal anchor that prevents nominal wages from increasing enough in each period to make the constraint still non-binding. We choose a simple nominal rule that attempts to capture the idea that central banks do not want to allow inflation to get too high (because of its associated costs) while still amenable to quantification in our business context. In particular, we assume that world nominal GDP in dollars grows at a constant and exogenous rate (which we set to zero without loss of generality). Then, as is common in the literature, we treat the Chinese shock as a productivity improvement in China that varies across industries and years. We calibrate these productivity changes and key model parameters to match the changes in US imports from China that we observe in the data (when projected onto other rich country changes in imports from China) as well as the regression results of Autor et al. (2013) on how labor force participation, unemployment, and population in US labor markets are affected by the China shock. This calibration procedure leads to a certain downward rigidity in nominal wages, which means that at a constant global nominal GDP, wages can fall by up to 2% per year without the constraint becoming binding. This value is similar to that of Schmitt-Grohe and Uribe (2016).

Armed with the calibrated version of our model, we simulate the effects of the China shock for the period 2000-2007 using exact dynamic hat algebra, so that we do not need to explicitly calibrate trade costs and productivity levels at sector level in the first year. . We find that downward nominal wage rigidity has critical qualitative and quantitative implications for how US states adjust to the Chinese shock. Specifically, we find that although the China shock improves the terms of trade for all but one US state, employment actually declines in most states during the transition, both due to an increase unemployment and a decline in labor force participation. This means that downward nominal wage rigidity not only amplifies terms-of-trade effects, but could also reverse these effects. For example, a favorable terms-of-trade shock that requires a sufficiently large decline in nominal wages for labor market adjustment would activate the nominal wage constraint and generate unemployment, which would be detrimental to the economy.

Intuitively, in a world where wages are flexible, increasing China’s relative productivity would require a downward adjustment in the US relative wage. Downward nominal wage rigidity prevents this adjustment from occurring via a sharp decline in the US nominal wage, and nominal anchoring prevents it from occurring via a large increase in the Chinese dollar wage. The result is temporary unemployment in the United States. In turn, this unemployment leads to further declines in labor market participation, as more workers prefer to withdraw from the labor market rather than face the possibility of being unemployed. The quantification of our model implies that the Chinese shock leads to the loss of about half a million jobs in the United States between 2000 and 2007. However, since the effect of unemployment reverses over time when the nominal wage adjusts downward, employment eventually increases after the economy has fully adjusted to the positive long-term terms-of-trade shock.

The spatial heterogeneity of the employment and income effects of the Chinese shock implied by our model is similar to that implied by the empirical results of Autor et al. (2013). This contrasts with previous quantitative business models, such as Caliendo et al. (2019) and Galle et al. (2022), which deliver too little dispersion, as shown by Adao et al. (2020) and Autor et al. (2021). The main reason why we obtain a higher dispersion is that, due to the downward rigidity of nominal wages, our model leads to much larger employment declines in the most exposed regions, both directly through higher unemployment and indirectly by discouraging work participation.

One of the advantages of having the structure of a general equilibrium model is that we can study the effect of the Chinese shock on welfare. We find a negative relationship between welfare changes and exposure to imports to China (see Figure 1). On the one hand, we find that an extra $1,000 per worker imported from China lowers state-level welfare by eight basis points. On the other hand, we find that despite the dispersion of welfare effects across state-sector pairs (see Figure 2), welfare increases in most US states, including many that experience unemployment during the transition. As a result, the Chinese shock benefits the United States, even with downward rigidity in nominal wages. However, downward nominal wage rigidity has important welfare implications, as it leads to a 25% reduction in US gains from the shock (from 31 to 23 basis points) and absolute welfare losses in seven states that would have benefited from the Chinese shock. otherwise.

Figure 1 Change in well-being from exposure to China shock in US states

Figure 2 Histogram of changes in well-being in different states-sectors of the United States

References

Adao, R, C Arkolakis and F Esposito (2020), “General Equilibrium Effects in Space: Theory and Measurement”, NBER Working Paper No. w25544.

Author, DH, D Dorn and GH Hanson (2013), “The China Syndrome: Local Labor Market Effects of Import Competition in the United States”, American Economic Review 103(6): 2121-2068.

Author, DH, D Dorn and GH Hanson (2021), “On the Persistence of the China Shock”, NBER Working Paper No. w29401.

Caliendo, L, M Dvorkin and F Parro (2019), “Trade and Labor Market Dynamics: General Equilibrium Analysis of the China Trade Shock”, Econometrics 87(3): 741-835.

Dorn, D and P Levell (2022), “Changing Perspectives on the Impact of Trade on Inequality in Rich Countries”, VoxEU.org, 14 February.

Galle, S, A Rodríguez-Clare and M Yi (2022), “Slicing the Pie: Quantifying the Aggregate and Distributional Effects of Trade”, Review of economic studies, coming.

Grossman, G and E Oberfield (2022), “Trying to account for the falling labor share”, VoxEU.org, 13 January.

Schmitt-Grohe, S and M Uribe (2016), “Downward nominal wage rigidity, currency pegs and involuntary unemployment”, Journal of Political Economy 124(5): 1466-1514.

Rodríguez-Clare, A, M Ulate and JP Vasquez (2022), “Trade with Nominal Rigidities: Understanding the Unemployment and Welfare Effects of the China Shock”, CEPR Working Paper 17141.