Premium
On the Terms of Trade and Sectoral Reallocations
Author(s) -
Dennis Benjamin N.,
İşcan Talan B.
Publication year - 2005
Publication title -
review of international economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.513
H-Index - 58
eISSN - 1467-9396
pISSN - 0965-7576
DOI - 10.1111/j.1467-9396.2005.00543.x
Subject(s) - economics , terms of trade , elasticity of substitution , small open economy , shock (circulatory) , production (economics) , flexibility (engineering) , open economy , monetary economics , international economics , macroeconomics , exchange rate , medicine , management
A commonly held view is that a small open economy adjusts to a negative external shock by switching both expenditure and resources toward the domestic traded goods sector. We show that, when both labor and imported inputs are used as factors of production, the average labor intensity in the nontraded sector may increase substantially with a decline in the terms of trade. This can lead to an internal transfer of labor into the nontraded sector, and an improvement in the trade balance even with a decline in traded sector output. This result depends on a combination of a high elasticity of substitution across nontraded varieties and large differences in labor intensities in the production of nontraded varieties. Our analysis suggests that intersectoral labor flows are not necessarily a good measure of an economy's flexibility, and that intersectoral resource reallocation and expenditure‐switching can move in opposite directions.