Optimal Trade Policy in a Ricardian Model with Labor-Market Search-and-Matching Frictions

This paper investigates a situation in which unemployment can justify the use of trade policy. The model is based on a Diamond-Mortensen-Pissarides frictional labor market and the standard Ricardian model of international trade. I show that free trade is optimal only when a labor market is initially constrained-efficient. The main finding is that a small open economy that is concerned about inefficiently high unemployment should use either an export subsidy or an import subsidy. This result can explain why developing countries tend to promote employment by subsidizing exports