PUBLICATIONS

World Commodity Prices and Partial Default in Emerging Markets: An Empirical Analysis (with Shuang Feng)
Review of World Economics, Forthcoming.

Most sovereign defaults are partial, with heterogeneous post-default outcomes, and commodity prices are an important determinant of sovereign default and the subsequent restructurings. In the case of emerging countries, as a result of direct dependence of government on revenues from commodity exports, declines in commodity prices reduce government’s resources to service the external debt thereby increase the chances of default. In this paper, we construct a country-specific commodity price index with time-varying weights based on commodity exports to quantify the impact of commodity prices on the partial default rate measured by debt arrears. We show that declines in commodity prices have a significant, positive effect on the default rate. The overall predicted effects for a one-standard deviation decrease in a composite of the level and change of the price index at its 1st, 2nd, and 3rd quartile, on average, are 14.2, 12.5, and 9.3 percentage points respectively. We also show that for a country-specific one-standard deviation decrease in the composite price index, the predicted effect varies from insignificant to an increase of 33.8 percentage points. The country-specific effect on the default rate generally increases in magnitude with a country’s dependence on commodity exports, while it depends heterogeneously on external indebtedness—increasing in magnitude for low levels (below a threshold of about 30 percent) of debt and decreasing thereafter.

Optimal Control of a Global Model of Climate Change with Adaptation and Mitigation (with Prakash Loungani, Helmut Maurer, and Willi Semmler)
Mathematical Control and Related Fields, Volume 13, Issue 2 (June 2023), pp. 583-604.

The economy-climate interaction and an appropriate mitigation policy for climate protection have been treated in various types of scientific modeling. Here, we specifically focus on the seminal work by Nordhaus [14, 15] on the economy-climate link. We extend the Nordhaus type model to include optimal policies for mitigation, adaptation and infrastructure investment studying the dynamics of the transition to a low fossil-fuel economy. Formally, the model gives rise to an optimal control problem consisting of a dynamic system with five-dimensional state vector representing stocks of private capital, green capital, public capital, stock of brown energy in the ground, and carbon emissions. The objective function captures preferences over consumption but is also impacted by atmospheric CO2 and by mitigation and adaptation policies. Given the numerous challenges to climate change policies the control vector is eight-dimensional comprising mitigation, adaptation and infrastructure investment. Our solutions are characterized by turnpike property and the optimal policies that accomplish the objective of keeping the CO2 levels within bound are characterized by a significant proportion of investment in public capital going to mitigation in the initial periods. When initial levels of CO2 are high, adaptation efforts also start immediately, but during the initial period, they account for a smaller proportion of government's public investment.

Investing in Public Infrastructure: Roads of Schools? (with Bin Li, Ricardo Marto, and Giovanni Melina) IMF Working Paper No. 17/105
Macroeconomic Dynamics, Volume 25, Issue 7 (October 2021), pp. 1892-1921.

Why do governments in developing economies favor roads rather than schools in public investment scale-ups? We study this question using a dynamic general equilibrium model and argue that the different pace at which roads and schools contribute to economic growth, public debt intolerance, and political myopia are central to this decision. In a thought experiment with a large return differential in favor of schools, a benevolent government would intuitively devote the majority of an investment scale-up to them. However, the fraction of schools chosen by the government falls with increasing levels of debt intolerance and political myopia. In particular, political myopia is a meaningful explanation for the observed result to the extent that an extremely myopic government would not invest in schools at all.

Re-Opening After the Lockdown: Long-Run Aggregate and Distributional Consequences of COVID-19 (with Chris Papageorgiou and Stephen J. Turnovsky)
Journal of Mathematical Economics, Volume 93 (March 2021), 102481, 18 pages.

Covid-19 has dealt a devastating blow to productivity and economic growth. We employ a general equilibrium framework with heterogeneous agents to identify the tradeoffs involved in restoring the economy to its pre-Covid-19 state. Several tradeoffs, both over time, and between key economic variables, are identified, with the feasible speed of successful re-opening being constrained by the transmission of the infection. In particular, while more rapid opening up of the economy will reduce short-run aggregate output losses, it will cause larger long-run output losses, which potentially may be quite substantial if the opening is overly rapid and the virus is not eradicated. More rapid opening of the economy mitigates the increases in both long-run wealth and income inequality, thus highlighting a direct conflict between the adverse effects on aggregate output and its distributional consequences

Taxation and Public Health Investment: Policy Choices and Tradeoffs (with Chris Papageorgiou and Stephen J. Turnovsky)
Macroeconomic Dynamics, Volume 25, Issue 2 (March 2021), pp. 426-461.

In recent years, there has been an explosive increase in the demand for health products and services by people all around the globe, and particularly in advanced economies. Aiming to enhance longevity and also to improve quality of life, individual consumption of pharmaceutical products and services has risen exponentially since the early 1980s. This paper develops a model in which agents invest part of their resources in medical products and time in physical exercise to enhance their health status. In the first part of the paper, we study the steady state and transitional dynamics of the model with special emphasis on the effects of health decisions on aggregate outcomes. In the second part, we explore how public health policies may alter private economic decisions that promote healthier and more productive lives.

Entry Costs, Task Variety, and Skill Flexibility: A Simple Theory of (Top) Income Skewness (with Yoshinori Kurokawa)
B.E. Journal of Macoeconomics, Volume 21, Issue 1 (January 2021), pp. 97-124.

This paper develops a simple model that provides a unified explanation for both an increase in below-top skewness and a much larger increase in within-top skewness of wage income distribution. It relies on a single mechanism based on the fixed costs of firm entry. A decrease in entry costs increases the variety of goods/tasks and thus the demand for higher-skilled workers who are more flexible in handling a variety of tasks, which increases both types of skewness. Differences in flexibility are modeled as differences in the fixed labor setup costs required to handle a given number of tasks. Our numerical experiments in a calibrated model show that a decrease in entry costs—entry deregulation—can be a quantitatively important source of both the increase in below-top skewness and the much larger increase in within-top skewness observed in the U.S. Moreover, the experiments imply that the observed differences in entry deregulation can cause significant differences in the top skewness across countries that have similar techno- logical change. This can provide an answer to Piketty and Saez’s (2006) question: Why have top wages surged in English speaking countries in recent decades but not in continental Europe or Japan, which have gone through similar technological change?

Intersectoral Linkages, Diverse Information, and Aggregate Dynamics (with Ryan A. Chahrour)
Review of Economic Dynamics, Volume 36 (April 2020), pp. 270-292.

What are the aggregate consequences of information frictions? We address this question in a multi-sector real business cycle model in which firms learn from market-based information. Theoretically, we present two distinct cases in which the aggregate effects of incomplete information completely disappear: either (i) market-based information reveals sector-level optimal actions, or (ii) market-based information reveals aggregate conditions in the economy. When the model is calibrated to United States’ sectoral data, both conditions hold almost exactly and incomplete information has a negligible effect on aggregate dynamics.

Rethinking Development Policy: Deindustrialization, Servicification, and Structural Transformation (with Prakash Loungani, Milton Marquis, and Chris Papageorgiou) IMF Working Paper No. 18/223
World Development, Volume 128 (April 2020), 104835, 13 pages.

This paper takes a fresh look at the current theories of structural transformation and the role of private and public fundamentals in the process. It summarizes some representative past and current experiences of various countries vis-a-vis structural transformation with a focus on the roles of manufacturing, policy, and the changing nature of global production in shaping the trajectory of structural transformation. The salient aspects of the current debate on premature deindustrialization and its relation to a middle-income trap are described as they relate to the path of structural transformation. Conclusions are drawn regarding prospective future paths for structural transformation and development policies as well as for the need for further empirical analysis to inform our current understanding of the process of economic development.

Moral Hazard in Lending and Labor Market Volatility (with John Gibson and Milton H. Marquis)
Journal of Money, Credit, and Banking, Volume 51, Issue 1 (February 2019), pp. 79-109.

When the economy experiences a sharp economic downturn, credit spreads widen and project financing costs for firms rise as funding sources begin to dry up. The economy experiences a lengthy recovery, with unemployment rates slow to return to “full employment” levels. We develop a model that displays these features. It relies on an interaction between labor search frictions and firm-level moral hazard that is accentuated during recessions. The model is capable of addressing the “Shimer puzzle,” with labor market variables exhibiting significantly more volatility on average as a result of the heightened moral hazard concerns during these episodes that significantly deepen and prolong periods of high unemployment, as vacancy postings fall dramatically and the job-finding rate declines. Our mechanism is also found to induce internal shock propagation causing the peak response of output, unemployment, and wages to occur with a several quarter delay relative to a model without such frictions. Many other labor market variables also show slower recovery—-their return to pre-shock level occurs at a slower place for a number of periods after the peak response.

Trade Costs and Endogenous Nontradability in a Model of Sectoral and Firm-Level Heterogeneity
Computational Economics, Volume 53, Issue 2 (February, 2019), pp. 709-742.

The paper takes a first step in the direction of simultaneously incorporating sectoral and firm-level heterogeneity in the models of international trade and macroeconomics in a tractable manner: without increasing the complexity of numerical computations compared to the existing models with heterogeneity in one dimension. In a model with sectoral heterogeneity in trade costs and firm-level heterogeneity in productivity, introducing one source of heterogeneity at a time and piecing together the results implies that, on reduction in trade costs, more goods and more varieties of every tradable good become traded. In contrast, in the correctly specified model with simultaneous heterogeneity in both dimensions, while more goods do indeed become tradable, but for more than 50% of the previously traded goods, the number of traded varieties falls. The model also reconciles apparently contrasting predictions for the differences in the deviation of domestic price from the world price for the traded and nontraded goods when heterogeneity is introduced, one dimension at a time.

Labor Market Volatility in the RBC Search Model: A Look at Hagedorn and Manovskii’s Calibration (with John D. Gibson and Milton H. Marquis)
Computational Economics, Volume 52, Issue 2 (August, 2018), pp. 583-602.

The standard Diamond–Mortensen–Pissarides (DMP) labor search model generates low volatility in labor market variables relative to average labor productivity, the so-called Shimer puzzle. Hagedorn and Manovskii (Am Econ Rev 98(4):1692–1706, 2008) demonstrate that recalibrating the standard DMP model to be consistent with the small vacancy posting cost and wage elasticity observed in the data can resolve the Shimer puzzle. They close by stating that their calibration strategy would also resolve the Shimer puzzle in the real business cycle (RBC) search framework. In this paper, we examine their claim and find that their strategy resolves the Shimer puzzle in the RBC search model for linear preferences (with risk neutrality and infinite Frisch elasticity of labor supply), but falls significantly short for more standard assumptions on the degree of relative risk aversion (of 1–2) and Frisch elasticity (of 2–3), in line with empirical estimates. While our conclusions are based on highly accurate solutions using the Generalized Stochastic Simulation Algorithm, we also assess the accuracy of a frequently used linearization method and its implications for the assessment of labor market volatility.

Asymmetry and the Amplitude of Business Cycle Fluctuations: A Quantitative Investigation of the Role of Financial Frictions (with John D. Gibson and Milton H. Marquis)
Macroeconomic Dynamics, Volume 22, Issue 2 (March, 2018), pp. 279-306.

We examine the quantitative significance of financial frictions that reduce firms’ access to credit in explaining asymmetric business cycles characterized by disproportionately severe downturns. Using rate spread data to calibrate the severity of these frictions, we successfully match several key features of U.S. data. Specifically, although output and consumption are relatively symmetric (with output being slightly more asymmetric), investment and hours worked display significant asymmetry over the business cycle. We also demonstrate that our financial frictions are capable of significantly amplifying adverse shocks during severe downturns. Although the data suggest that these frictions are only active occasionally, our results indicate that they are still a significant source of macroeconomic volatility over the business cycle.

Fiscal Adjustment and Inflation Targeting in Less Developed Countries (with Ed Buffie)
Journal of Money, Credit, and Banking, Volume 48, Issue 8 (Dec, 2016), pp. 1839-1875.

Inflation targeting may not be viable in LDCs where policy makers rely too heavily on cuts in infrastructure investment to balance the budget. Using a mix of analytical and numerical methods, we demonstrate that the equilibrium ceases to be saddlepoint stable under active policy when infrastructure cuts account for 30-70% of fiscal adjustment and the return on infrastructure exceeds a comparatively low threshold value. The result is robust to the form of the Taylor rule, the degree of real wage flexibility, the initial level of debt, the choice of a balanced-budget or debt-targeting rule, and the q-elasticity of private investment spending.

The Impact of Trade Margins on the Skill Premium: Evidence from Mexico (with Yoshinori Kurokawa)
Journal of Policy Modeling, Volume 38, Issue 5, (Sep-Oct, 2016), pp. 895-915.

This paper formulates a static applied general equilibrium model of a small open economy and then calibrates it to the Mexican input-output matrix for 1987. We use the calibrated model to quantify how much of the dramatic rise in the skill premium over the period 1987-1994, following the liberalization of the trade policy in Mexico, can be accounted for by the change in the extensive margin of trade or trade variety. Our numerical experiments show that the increase in the extensive margin of Mexican manufactured trade with the U.S. can account for up to approximately 12 percent of the actual increase in skill premium in Mexico from 1987 to 1994.

Equilibrium Shirking, Access to Credit, and Endogenous TFP Fluctuations (with Tor Einarsson and Milton H. Marquis)
Economica, Volume 82, Issue 327 (Jul, 2015), pp. 486-507.

This paper develops a model in which idea-rich, cash-poor entrepreneurs undertake risky investment projects that are subject to future stochastic liquidity needs and to the potential for shirking due to moral hazard that reduces the likelihood that the projects will succeed. The model suggests that the strength of the incentive for the entrepreneur to shirk is countercyclical, and that endogenous shirking adds volatility to the economy by increasing the persistence and volatility of TFP. This result is the consequence of a greater variation in the number of projects being successfully completed. This variation is compounded by the effect of shirking incentives on the access to credit. The changes in factor employment play only a minor role for the increase in volatility.

Resurrecting the Weak Credibility Hypothesis in Models of Exchange-Rate-Based Stabilization (with Ed Buffie)
European Economic Review, Volume 56, Issue 3 (Apr, 2012), pp. 361-372.

We analyze how weak credibility affects the volatility of consumption spending in a model of exchange-rate-based stabilization that allows for both durable and nondurable goods. The inclusion of durables greatly improves the explanatory power of the weak credibility hypothesis. The hypothesis can account for the main qualitative properties of the boom-bust cycle provided the elasticity of durables expenditure with respect to Tobin’s q is greater than the intertemporal elasticity of substitution. Moreover, the quantitative effects are very large. In numerical simulations based on conservative assumptions about the expenditure share of durables (20%) and wealth effects (none), aggregate consumption increases 12-28% during the low-crawl phase and the real exchange rate appreciates 24-26%. In variants of the model that incorporate supply effects, the consumption boom is equally strong but appreciation of the real exchange rate rises to 30-40%.

Trade, Growth, and Poverty in Zambia: Insights from a Dynamic General Equilibrium Model (with Ed Buffie)
Journal of Policy Modeling, Volume 34, Issue 2, (Mar-Apr, 2012), pp. 211-229.

Many LDCs suffer from low levels of private investment, from acute shortages of social and physical infrastructure, and from widespread poverty and underemployment. How can trade policy help combat these problems? Neoclassical trade theory objects that the premise of the question is incorrect. According to the Principle of Targeting, it is better to use other policy instruments to counteract market imperfections and to target social objectives. Instead of interfering with free trade, the government should increase domestic taxes to pay for employment subsidies, investment subsidies, transfers to the poor, and additional public investment in infrastructure. Policy makers reject this advice as impractical. Our objective in this paper is to restart the policy dialogue. We build a dynamic general equilibrium trade model that is rich in structural detail and policy instruments but not a black box. We use the model to investigate how trade policy affects poverty, underemployment, aggregate capital accumulation, and real output in Zambia. The results consistently recommend policy packages that combine an escalated structure of protection with an escalated structure of export promotion. There is no support for the view that free trade or a low uniform tariff is approximately optimal.

Growth and Inequality: Dependence on the Time Path of Productivity Increases (and Other Structural Changes) (with Santanu Chatterjee and Stephen J. Turnovsky)
Journal of Economic Dynamics and Control, Volume 36, Issue 3 (Mar, 2012), pp. 331-348.

This paper examines the significance of the time path of a given productivity increase on growth and inequality. We show that whereas the time path impacts only the transitional path of aggregate quantities and has no effect on their ultimate steady-state levels, it has both transitional and permanent consequences for wealth and income distribution. As a result, the growth-inequality tradeoff generated by a given discrete increase in productivity contrasts sharply with that obtained when the same ultimate productivity increase is acquired gradually. This is true both in transition and across steady states. We show that a gradual productivity change can generate a Kuznets-type inverted U-shaped relationship between inequality and per-capita income. The distance from the technology frontier is also shown to have important implications for both the magnitude and persistence of inequality. Finally, our results suggest that economies with similar aggregate structural characteristics may have very different outcomes for income and wealth inequality, depending on the intrinsic nature of the productivity growth path.

Solving the Unit Root Problem in Models with an Exogenous World Market Interest Rate (with Ed Buffie)
Macroeconomic Dynamics, Volume 15, Issue 5 (Nov, 2011), pp. 681-712.

The standard model of the small open economy is saddled with a unit root that greatly complicates numerical computation of the global saddle path. In this paper we solve the unit root problem by developing a set of innovative forward-shooting algorithms. Exploiting the fact that the algorithms are mechanical and model-free, we have placed canned, fully automated programs in the public domain. The programs do not require any substantive human input. The user’s only responsibility is to type in the equations of the model correctly.

Exchange-Rate-Based Stabilization, Durables Consumption, and the Stylized Facts (with Ed Buffie)
Economic Journal, Volume 121, Issue 555 (Sep, 2011), pp. 1130-1160.

In this paper we show that a model featuring durable consumer goods, imperfect substitution between domestic and foreign assets, and weak credibility can explain the qualitative and quantitative aspects of the stylized facts associated with exchange-rate-based stabilization, including the tremendous increase in real interest rates. Following a temporary reduction in the crawl, total consumption spending rises 14-26%, the real exchange rate appreciates 20-37%, and the current account deficit swells to 10-15% of GDP. Despite large capital inflows, the real interest rate increases from 10% to 20-100%.

Linearization and Higher-Order Approximations: How Good are They? (with Bassam Awad and Milton H. Marquis)
Computational Economics, Volume 38, Issue 1 (Jun, 2011), pp. 1-31.

The standard procedure for analyzing transitional dynamics in non-linear macro models has been to employ linear approximations. Recently quadratic approximations have been explored. This paper examines the accuracy of these and higher-order approximations in an endogenous growth model with public capital, thereby extending the work done in the current literature on the neoclassical growth model. We find that significant errors may persist in computed transition paths and welfare even after resorting to approximations as high as fourth order. Moreover, the accuracy of approximations may not increase monotonically with the increase in the order of approximation. Also, as in the previous literature, we find that achieving acceptable levels of accuracy when computing the welfare consequences of a policy change typically requires a higher order approximation than attaining similar levels of accuracy in the computation of the transition path: typically an increase in order of approximation by one is sufficient.

Relative Wealth Concerns and Entrepreneurship (with Kislaya Prasad)
Economica, Volume 78, Issue 310 (Apr, 2011), pp. 294-316.

We develop a model of occupational choice and entrepreneurship in which market frictions limit the possibilities for diversifying entrepreneurial risk. A concern for relative standing arises in this model even though individuals care only about the consumption of standard commodities. In contrast to the complete markets outcome, an increase in sector-specific aggregate risk increases entrepreneurship due to relative wealth concerns. A change in the profile of the economy to include more risk-averse people results in an even greater increase in entrepreneurship. Thus, relative wealth concerns mitigate the reduction in entrepreneurship arising from the non-diversifiability of entrepreneurial risk. We examine the effects of uncertainty about economic policies such as market-based reforms on entrepreneurship.

Understanding Liquidity Shortages During Severe Economic Downturns (with Tor Einarsson and Milton H. Marquis)
Journal of Economic Dynamics and Control, Volume 35, Issue 3 (Mar, 2011), pp. 330-343.

One feature of economic recessions is the appearance of aggregate liquidity shortages that can exacerbate the economic downturn. We develop a model in which the demand for liquidity arises suddenly in response to continued funding needs of partially completed investment projects whose outcomes are subject to idiosyncratic shocks and moral hazard. When the economy experiences an adverse aggregate productivity shock, incentive constraints that underlie equity contracts may bind, provided the shock is severe enough. In this case, credit-rationing appears, and the heightened demand for liquidity coincides with a greater reluctance to take on equity positions or deepen investments in on-going investment projects. The consequence is a reduction in new investment and termination of on-going projects due to a lack of liquidity, thereby worsening the economic slowdown.

How Misleading is Linearization? Evaluating the Dynamics of the Neoclassical Growth Model (with Santanu Chatterjee and Stephen J. Turnovsky)
Journal of Economic Dynamics and Control, Volume 34, Issue 9 (Sep, 2010), pp. 1550-1571.

The standard procedure for analyzing transitional dynamics in non-linear macro models has been to employ linear approximations. This paper investigates the reliability of this procedure in evaluating the dynamic adjustments to policy changes or structural shocks. We analyze this issue using the example of a Ramsey growth model, with two alternative specifications of productive government spending. If government expenditure is introduced as a flow and the dynamic adjustment is fast, linearization may be a reasonably good approximation of the true dynamics even for fairly large policy shocks. If government expenditure assumes the form of a stock, leading to more sluggish adjustment, linearization is more problematic. It may yield misleading predictions, both qualitatively and quantitatively. These errors occur at the beginning of the transition and weigh heavily in welfare calculations. The implications for these errors for temporary shocks and the speed of convergence are also considered.

Public Investment, Tax Evasion, and the Welfare Effects of a Tariff Reform
Contemporary Economic Policy, Volume 28, Issue 2 (Apr, 2010), pp. 219-239.

Contrary to the case considered in literature, experience of developing countries indicates that trade reforms have not been revenue neutral due to the heavy dependence of developing countries on trade taxes and pervasive tax evasion. In contrast to the plausibility of a welfare loss shown by the current literature, when the adverse effect of loss of tariff revenue on public investment is factored in the welfare outcomes of tariff reforms of past few decades turn out to be much more pessimistic. The success of future attempts at tariff reforms would require preceding such reforms with empowerment of governments with ability to fight tax evasion and strengthen domestic tax system. For countries of sub-Saharan Africa where such reforms are likely to be concentrated, this would need planning and capacity building over a longer time horizon.

Reverse Shooting Made Easy: Automating the Search for the Global Nonlinear Saddle Path (with Ed Buffie)
Computational Economics, Volume 34, Issue 3 (Oct, 2009), pp. 273-308.

We present the blueprints for a set of innovative reverse shooting algorithms that trap the global saddle path in systems with 2-4 state variables. The solution procedure is built around a new distance mapping and refined simplex algorithms. Since the algorithms are completely reliable and always work in the same way, we have been able to develop canned problems that solve for the global nonlinear saddle path in any model with 2-4 state variables. The programs are written in the spirit of plug and play: the user types in the equations of the model and then waits for the solution. (Link to the longer version of the paper)

Agricultural Input Subsidies in Malawi: Good, Bad or Hard to Tell? (with Ed Buffie)
FAO Commodity and Trade Policy Research Paper, No. 28 (Aug, 2009).

We investigate the impact of a large Agricultural Input Support Program-type increase in input subsidies on GDP, food security, and real income of the poor. To bring more clarity to the policy debate, we develop a dynamic general equilibrium model in which agricultural input subsidies can be directly compared with alternative anti-poverty strategies. The model features a full array of imports (intermediates, consumer goods, and capital goods), transport and distribution costs, sector-specific capital, public investment in physical infrastructure, production for own-consumption, and separate small and large-scale agricultural sectors. It is also firmly grounded in optimizing behavior. The general equilibrium dynamics for the economy emerge from the intersection of market-clearing conditions with the government budget constraint and the perfect foresight solutions to private agents’ optimization problems. Not surprisingly, the grades on the report card for the subsidy program depend on how the subsidies are financed, on the return on public investments that compete for scarce government funds, and on the size of the productivity gains smallholders reap from increased application of fertilizer + seed packs.

Smart Forward Shooting (with Ed Buffie)
Computational Economics, Volume 33, Issue 1 (Feb, 2009), pp. 1-30.

In this paper we develop a set of innovative forward-shooting algorithms that solve for the global nonlinear saddle path in models with 1-3 jump variables. Exploiting the fact that the algorithms are mechanical and model-free, we have placed canned, fully-automated programs in the public domain. The programs do not require any substantive human input. The user’s only responsibility is to type in the equations of the model correctly.

Trade Liberalization and Rising Wage Inequality in Latin America: Reconciliation with HOS Theory
Journal of International Economics, Volume 71, Issue 2 (Apr, 2007), pp. 467-494.

The paper puts forward the hypothesis that the transitory effects of trade liberalization on wage inequality can differ from the long-run outcome. In cases where the HOS theory predicts a decline in wage inequality in the long run, a temporary rise can, nevertheless, occur due to (i) the asymmetries in the speed of contraction in the import sector and expansion in other sectors, and (ii) the capital-skill complementarity in production. The asymmetric contraction and expansion causes a transitory capital accumulation that boosts the relative and the real wage of skilled labor due to capital-skill complementarity. Although the long-run HOS fundamentals are, therefore, dominated in the short run by the transient effects arising due to capital-skill complementarity, the observed rise in wage inequality is nonetheless consistent with the HOS theory appropriately extended to a dynamic setting.