External terms-of-trade and labor market imperfections in developing countries: theory and evidence

The paper addresses the question of whether developing countries possess any built-in mechanism that can cope with external terms-of-trade (TOT) shocks. Using a two-sector, full-employment general equilibrium model with endogenous labor market distortion theoretically it shows that such countries possess an inherent shock-absorbing mechanism that stems from their peculiar institutional characteristics and can lessen the gravity of detrimental welfare consequence of exogenous TOT movements. This result has been found to be empirically valid based on a panel dataset of 13 countries from 2000-2012. Our analyses lead to recommendation of an important policy that should be adhered to preserve this in-built system.