Trade and Global Income Inequality with Frictional Labor Markets: A Lesson from the Canada–US Free Trade Agreement

Abstract

This paper develops a two-country trade model with frictional labor market structures to investigate the link between increased openness to trade and cross-country income inequality. Calibrated to US–Canadian data, the model simulation results show that the Canada–US Free Trade Agreement benefited Canada, the country with relatively higher capital intensity, more due to its capacity to flexibly expand in response to an increase in product demand. The results from counterfactual experiments indicate that increased capital intensity in the US is expected to increase gains from trade in both countries while making the distribution of gains less unequal.