International Borrowing, Specialization and Unemployment in a Small, Open Economy
Empirical evidence suggests that the unemployment rate and the export/GNP ratio are positively correlated with external debt across developing countries. This paper develops a dynamic model that provides an explanation for the aforementioned relationships. The central idea of our paper is that international borrowing affects unemployment and specialization patterns by unevenly changing the risk-sharing structure - across sectors - between firms and workers. The economy produces a domestic good and an export good and faces uncertainty in its terms of trade. Unlike the domestic good, the production process for the export good lasts two periods and requires borrowing by firms in period one. To insure workers against income fluctuations, firms in the export sector find it optimal to offer an implicit contract through stable wages. This wage contract allows firms to lay off some workers in bad states of nature. An increase in international borrowing allows firms in the export sector to offer wage contracts to more workers thereby increasing the extent of specializatrion in the export good. As labour shifts from the domestic good sector into the more efficient export sector, a bad realization in the terms of trade results in higher unemployment. The paper shows conditions under which a state-contingent price subsidy will reduce the unemployment rate without (inefficiently) reducing the extent of specialization in the comparative advantage good.
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- Cole, Harold L & Dow, James & English, William B, 1995.
"Default, Settlement, and Signalling: Lending Resumption in a Reputational Model of Sovereign Debt,"
International Economic Review,
Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(2), pages 365-85, May.
- Harold L. Cole & James Dow & William B. English, 1994. "Default, settlement, and signalling: lending resumption in a reputational model of sovereign debt," Staff Report 180, Federal Reserve Bank of Minneapolis.
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- Baily, Martin Neil, 1974. "Wages and Employment under Uncertain Demand," Review of Economic Studies, Wiley Blackwell, vol. 41(1), pages 37-50, January.
- Diwan, Ishac, 1990. "Linking trade and external debt strategies," Journal of International Economics, Elsevier, vol. 29(3-4), pages 293-310, November.
- Chang, P. H. Kevin, 1991. "Export diversification and international debt under terms-of-trade uncertainty : An intertemporal approach," Journal of Development Economics, Elsevier, vol. 36(2), pages 259-277, October.
- Azariadis, Costas, 1975. "Implicit Contracts and Underemployment Equilibria," Journal of Political Economy, University of Chicago Press, vol. 83(6), pages 1183-1202, December.
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