External terms-of-trade and labour market imperfections in developing countries: Theory and evidence

Purpose Some recent empirical studies have found that developing countries are more prone to external terms-of-trade shocks compared to developed nations. With this background, the purpose of this paper is to the question of whether developing countries possess any built-in mechanism that can cope with external terms-of-trade (TOT) shocks both theoretically and empirically. Design/methodology/approach This paper uses a two-sector, full-employment general equilibrium model with endogenous labour market distortion to conduct its theoretical analysis and then uses an annual panel dataset of 13 small developing countries over the recent time period of 2000-2012 to substantiate its theoretical findings. Findings Theoretically, this study finds that developing countries possess an inherent shock-absorbing mechanism that stems from their peculiar institutional characteristics and can lessen the gravity of detrimental welfare consequence of exogenous TOT movements. This analytical result has been found to be empirically valid based on a panel dataset of 13 countries from 2000-2012. Originality/value The authors' analyses suggest that that the developing countries should take utmost caution before adopting the policy of labour market reform because these might impair the effectiveness of their in-built shock-absorbing mechanism against adverse international price movements.