Terms-of-Trade Uncertainty, Incomplete Markets and Unemployment.

This paper examines a two-sector small open economy that is subject to shocks in its terms-of-trade. Risk-neutral entrepreneurs use implicit contracts to insure risk-averse workers against fluctuations in their income. The characteristics of these contracts are examined within a general framework and the implications for employment, wages, and utility of different realizations of relative prices are analyzed. The implicit contract equilibrium is shown to be constrained Pareto optimal when the social planner is unable to provide income directly to unemployed workers. Copyright 1992 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.