Tariffs, Terms of Trade, Unemployment and the Real Exchange Rate

Abstract

The less developed countries (LDCs) have been subjected to major exogenous shocks and drastic domestic policy changes in recent years. These shocks include changes in the terms of trade and/ or a policy shift away from the pervasive protectionism of the previous decades. The implementation of trade liberalization programs is likely to follow in many more developing countries. A large body of theoretical and empirical literature has developed which attempts to analyze the consequences of these changes, utilizing models which explicitly incorporate the main structural and institutional characteristics of the LDC economies.' The behavior of the real exchange rate, defined in various ways, but most commonly as the relative price of tradeables to non-tradeables, has been identified as being of central analytical and policy importance. While the literature on this subject recognizes the key link between the real exchange rate and domestic wages, the analytical models used generally suffer from serious limitations in terms of their characterization of the labor markets. The models used in the literature can be categorized into two groups: (a) flex-price models that give rise to full employment, and (b) models that assume full or partial wage rigidity thereby generating some form of unemployment. Conventional wisdom suggests that a rise in import tariffs or an improvement in the terms of trade would always lead to an appreciation of the real exchange rate. However, it is shown by Clague [3] and Edwards and van Wijnbergen [11] that the above result does not necessarily hold in more general models. However, these analyses were restricted to models with flexible wages. Wage rigidity is often ascribed to the existence of some form of wage indexation or other forms of government inter-