Abstract: Trade in intermediates, also known as unbundling of production, and trade in capital have become increasingly important in the world economy during the last twenty-five years. To jointly study these two phenomena, we develop a dynamic, factor-proportions model with trade in final goods, intermediates and capital where countries differ in their aggregate productivity levels (TFP). Our central result is to identify a novel channel whereby trade in intermediates generates a reallocation of capital across countries that exacerbates world inequality in both income and welfare. With unbundling, high-productivity countries sort into the production of capital-intensive intermediates. They increase their capital stock (via capital imports and accumulation), and, ultimately, their real wages. This exacerbates initial productivity differences across countries and increases world income inequality. We also show that income inequality rises with unbundling (i) even in the case of ex-ante identical countries (symmetry breaking), (ii) when emerging countries start participating in trade in intermediates and (iii) when a labor-saving technology (computerization) is introduced. For an empirically-motivated model parametriza tion, middle-income countries experience the largest output decline with unbundling.

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