Mobility Costs and the Dynamics of Labor Market Adjustments to External Shocks: Theory1

We construct a dynamic, stochastic rational expectations model of labor reallocation that is designed so that its key parameters can be estimated for trade policy analysis. A key feature is the presence of time-varying idiosyncratic moving costs faced by workers. As a consequence of these shocks: (i) Gross ‡ows exceed net ‡ows (an important feature of empirical labor movements); (ii) the economy features gradual and anticipatory adjustment to aggregate shocks; (iii) wage di¤erentials across locations or industries can persist in the steady state; and (iv) the normative implications of policy can be very di¤erent from a model without idiosyncratic shocks, even when the aggregate behaviour of both models is similar. It is shown that the solution to a particular planner’s problem yields a competitive equilibrium, thus facilitating the analysis and simulation of the model for policy analysis. 1We are grateful to seminar participants at the Board of Governors of the Federal Reserve System; Koç University; Syracuse University, University College London, the University of Virginia, and the World Bank; to participants of the European Research Workshop in International Trade, July, 2000 and the Summer Institute of the National Bureau of Economic Research, August 2001; and also to Bill Gentry, Ann Harrison, Glenn Hubbard, and Marc Melitz for comments. Erhan Artuc provided excellent research assistance. This project is supported by NSF grant 0080731.