International Trade when Inequality Determines Aggregate Demand

In this paper we model 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. We relax this assumption and 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, we introduce preferences where consumers rank indivisible goods according to a hierarchy of both needs and desires. In the model we assume that the distribution of wealth is unequal in the less developed country and even in the industrialized country. We show that the composition of the aggregate consumption basket in the integrated economy depends on both interand intra-national inequality. Hence, we identify a demand channel through which inequality affects the international trade pattern. Empirical evidence from a panel of bilateral trade data among 57 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.