International Trade when Inequality Affects Aggregate Demand

The model derives the pattern of international trade between rich and poor countries, 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 Engelís Law: The budget share allocated to necessities falls with income. To account for the impact of income distribution, preferences are such that consumers rank indivisible goods according to a hierarchy of both needs and desires. The composition of the aggregate consumption basket in the integrated economy depends on both inter- and intra-national inequality. 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.