Mobility Costs and the Dynamics of Labor Market Adjustment to external Shocks: Theory

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 flows exceed net flows (an important feature of empirical labor movements); (ii) the economy features gradual and anticipatory adjustment to aggregate shocks; (iii) wage differentials across locations or industries can persist in the steady state; and (iv) the normative implications of policy can be very different from a model without idiosyncratic shocks, even when the aggregate behavior 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 purposes.