Modelling the Sectoral Allocation of Labor in Open Economy Models

Abstract

Indivisible labor is not the only type of nonconvexity affecting labor supply decisions. Another type of nonconvexity arises in economies with sectors whenever individuals can work in only one sector at a time. I introduce this restriction into an open economy model with a tradeable and a nontradeable sector, and I use lotteries to convexify the consumption possibilities set. This approach implies that the aggregate elasticity of labor supply becomes infinite. I compare the performance of the model with an analogous model in which the labor supply elasticity is finite. I find that there is a disconnect between the response of wages to monetary shocks and the open economy variables. The labor supply elasticity plays a more important role in the transmission of technology and government expenditure shocks to the real exchange rate and the terms of trade.

Keywords: Tradeable and nontradeable sectors; International business cycles; Labour supply elasticity

JEL Classification: E24, E32, F41