The Virtues of Flexibility: Import Dependence and External Shocks

This paper considers how the structure of an open economy determines its flexibility in responding to external shocks. Inter- and intrasectoral reallocation of both expenditures and factors of production are shown to mitigate the consequences of a severe terms-of-trade shock. We demonstrate that the degree of flexibility resulting from these reallocative effects depends partly on intrasectoral differences (i.e., sectoral heterogeneity) in import dependence. The paper introduces sectoral heterogeneity by allowing the relative shares of labour and imported inputs used in production to differ across monopolistically competitive industries. Flexibility is shown to be reduced by: (i) low technological diversity, which constrains sectoral heterogeneity and hence the scope of factor reallocation, and (ii) high market power (i.e., low market competition), which curbs expenditure substitution across different consumption goods in the wake of a shock. The empirical implications of the model are demonstrated using sectoral data from Mexico.