Terms of Trade, Labor Supply and the Current Account

Abstract

This paper studies the effect of the terms of trade on labor supply, industrial capital adjustment and the current account in a two-period small open economy in which endogenous labor supply is considered and labor is assumed to be mobile between sectors, given the situation that capital is a sector-specific factor in the short run but is mobile between sectors in the long run. In this setup, the effect of a permanent deterioration in the terms of trade on the current account will depend on the industry capital-labor ratio. This is due to the assumption of an elastic labor supply, short-run capital specificity, and long-run capital mobility between sectors. A temporary deterioration in the terms of trade on the current account is also ambiguous, since it is both a temporary deterioration in the terms of trade that reduces real income, and it also has an uncertain effect on the real wage due to the short-run fixed capacity result of the indeterminate labor supply in the two periods.