International trade when inequality determines aggregate demand

Abstract

The model in this paper characterizes the pattern of international trade, and technological innovation and imitation between industrialized and developing regions, when preferences are nonhomothetic. By and large, models of the dynamics of North-South trade impose the assumption of unit income elasticity for all consumption goods. This assumption is relaxed to incorporate the insight from Engel's Law: The budget share allocated to necessities falls with income. Since the composition of individual consumption depends on income, aggregate demand for newly invented goods depends not only on the distribution of income across countries but also within countries. To account for the impact of income distribution, preferences are introduced where consumers rank indivisible goods according to a hierarchy of both needs and desires. In the model, the distribution of wealth is unequal in the less developed country and even in the industrialized country. Then, the composition of the aggregate consumption basket in the integrated economy depends on both inter- and intra-national inequality. Hence, a demand channel is identified through which inequality affects the international trade pattern. Empirical evidence from a panel of bilateral trade data among 58 countries, for which adequate income distribution measures exist, and spanning three decades supports the conjecture that high inequality in a trading partner yields less bilateral trade flows through lower imports, after controlling for both observed and unobserved heterogeneity.

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