Terms of Trade, Labor Supply and the Current Account

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.