Productivity Gains Biased Toward the Traded Sector and Labor Market Frictions

This paper develops a tractable version of a two-sector open economy model with search frictions in order to account for the relative price and relative wage effect of technology shocks biased toward the traded sector. Using a panel of eighteen OECD countries, our estimates show that higher productivity in tradables relative to non trad- ables causes an appreciation in the relative price of non tradables along with a decline in non traded relative to traded wages while both responses display a considerable dis- persion across countries. The fall in the relative wage reveals the presence of mobility costs preventing wage equalization across sectors, while the cross-country dispersion in the relative wage responses suggest differences in labor market regulation. Using a set of indicators capturing the heterogeneity of labor market frictions across economies, we find that the relative wage significantly declines more and the relative price appreciates less in countries where labor market regulation is more pronounced. We show that these empirical findings can be rationalized in a two-sector open economy model with search in the labor market as long as we allow for an endogenous sectoral labor force participation decision. When we calibrate the model to country-specific data, the model performs well in reproducing the cross-country pattern in the relative wage responses and to a lesser extent in the relative price changes. While the responses of the relative wage and the relative price display a wide dispersion across countries, both display a significant negative relationship with labor market regulation.