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.