Abstract

A central feature of developing economies is the existence of dual labor markets, with an organized formal sector usually subject to a binding wage floor, and an informal sector which pays lower wages and where entry is free. It has also been observed in the literature that the preponderance of tradable and non-tradable goods are produced in the formal and informal sectors, respectively. This paper highlights the role played by these stylized structural features in determining policy outcomes in developing economies. We consider an economy where workers employed in the informal sector face some probability of being offered a job in the high-wage formal sector but this probability increases if they do not work but actively search for such a job, i.e., there exists a job search premium. We show that the job search premium and relative size of the informal sector are key elements that affect the results of policy changes with regard to sectoral wage differentials, argue that devaluation reduces the trade balance and may be contractionary, and that policies to increase the efficiency of labor exchange have an independent effect on the real exchange rate.

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