The nature and extent of labor market segmentation in developing countries has been the subject of much debate over the years, particularly in the context of discussions related to urbanization, migration, and trade and structural reforms. By contrast, the implications of various types of labor market dualism for short-run determination of output and employment in an open economy have not received much attention.
This paper examines the implications of labor market segmentation and imperfect labor mobility for the short-run dynamics associated with macroeconomic policy shocks, using a two-sector optimizing model of a small open economy. Firms in the traded goods sector determine both wages and employment, whereas wages in the nontraded goods sector are determined by the equilibrium condition between supply and demand. In addition, labor productivity in the traded goods sector is assumed to depend on relative wages. In equilibrium, firms in the traded goods sector always set the real wage above the level that prevails in the nontraded goods sector.
The case in which labor is homogeneous and perfectly mobile across sectors is considered first. The analysis shows that a permanent, unanticipated reduction in the devaluation rate leads to a drop in real wages in the traded goods sector and an instantaneous reallocation of labor away from the nontraded goods sector.
The model is then extended to workers whose movements across sectors occur gradually. The behavior of the economy with labor and/or job heterogeneity is shown to be qualitatively similar to the previous case when the speed of adjustment of labor to changes in expected payoffs is large, except that unemployment will typically emerge in equilibrium. However, a deflationary policy may not necessarily lead to an increase in unemployment in the short run. Firms in the traded goods sector do not reduce wages in the face of persistent sectoral unemployment because to do so would reduce productivity. When the speed of adjustment of labor is small, fluctuations in wages, employment, and output are dampened, but the transitory fall in the unemployment rate associated with a reduction in the devaluation rate will also be attenuated.