Empirical evidence suggests that the flexibility of labor supply is closely related to the dynamic adjustment of the real exchange rate. This paper investigates this relationship in a two-sector dependent economy model. While, the long-run equilibrium real exchange rate is independent of the elasticity of labor supply, our analysis confirms that the nature of the labor supply can be a crucially important determinant of its short-run dynamics. The extent to which this is so depends to some degree on the source of the underlying structural change that is driving the dynamics of the real exchange rate. Numerical simulations confirm that this mechanism may help explain the larger shortrun volatility and more rapid convergence typically associated with developing countries having less flexible labor markets.
August 2010 JEL Classification code: F 31, F41Keywords: Elastic labor supply; Real exchange rate; Persistence, Volatility *Turnovsky's research was supported in part by the Castor endowment at the University of Washington. 1
IntroductionThe real exchange rate (RER) puzzle has spawned an extensive literature, stimulating researchers to propose different explanations [Rogoff, 1996;Betts and Devereux, 1996;Hau, 2000;Obstfeld and Rogoff, 2001;Bergin and Feenstra, 2001;Chari, Kehoe, and McGrattan, 2002;Devereux and Engel, 2002;Morshed and Turnovsky, 2004;Chen and Hsu, 2009;Carvalho and Nechio, 2010]. Two key aspects of the puzzle are: (i) the long-term persistence of the real exchange rate following a structural change, and (ii) its short-term volatility, both of which exhibit systematic patterns across economies. With respect to the persistence of the real exchange rate, the rate of convergence to its long-run equilibrium value is significantly slower for developed countries than it is for developing countries [Cheung and Lai, 2000]. These authors examined a number of structural characteristics such as inflation, productivity growth, trade openness, and the size of government spending to account for these cross-country differences in the rate of convergence. They observe that only inflation and government spending yield a weak relationship with the observed pattern of persistence. Consequently, their findings underscore the need to identify the determinants of the persistence of the PPP deviation in order to explain these differences. 1 With regard to volatility, Hausmann, Panizza, and Rigobon (2006) show that developing countries have substantially more volatile real exchange rates than do developed countries, a difference that cannot be explained by differences in the magnitudes of the underlying shocks. 2 In addition, Hau (2002) finds that increased openness is associated with less volatility in the real exchange rate.
3A natural framework for addressing the dynamics of the real exchange rate is the dynamic "dependent-economy model", which determines the real exchange rate within a two-sector production framework. 4 But if one employs the standard Heckscher-Ohlin production structure, in 1 In a separate, ...
