International borrowing, specialization, and unemployment in a small open economy

The authors show that an increase in international borrowing increases specialization and unemployment in a small open economy that is subject to terms-of-trade risks. The economy has a production advantage in the export sector. However, the size of the export sector is limited by the available funds. To insure workers against income fluctuations arising from terms-of-trade risks, firms in the export sector offer workers a stable wage rate with the possibility of unemployment. An increase in international borrowing increases specialization in the export sector, which leads to higher unemployment when the terms-of-trade shock is bad. A state-contingent price subsidy can reduce unemployment without inefficiently reducing specialization. The results are robust to the introduction of risk-averse firms.