|Author Name||Noel GASTON (University of South Australia) / YOSHIMI Taiyo (Chuo University)|
|Creation Date/NO.||April 2020 20-E-032|
|Research Project||Exchange Rates and International Currency|
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We incorporate different sectoral job separation rates into a two-sector small open economy model to investigate the Balassa-Samuelson (B-S) effect. While labour is mobile, unemployment occurs due to search frictions. In addition, unequal separation rates give rise to compensating wage differentials. When productivity grows in the tradeables sector, labour moves from the tradeables sector to the nontradeables sector if tradeables and nontradeables are complements in consumption. Nevertheless, unemployment always falls due to the positive income effect. We also find that the effect of productivity growth in the tradeables sector on the real exchange rate is reduced by almost 38 per cent when separation rates differ across sectors and tradeables and nontradeables are complements. Overall, an overvaluation of the real exchange rate in the basic B-S model can be explained by heterogeneous job separations.