Knowledge that Transforms

The paper investigates the optimal time path of consumption and external borrowing in the dependent economy model. The small country faces given world prices and a given world real interest rate. The presence of a home goods sector implies that the relevant real interest rate appropriate to consumption decisions depends on the rate of change of the real price of home goods. The paper shows how transitory disturbances in output or in the world real interest rate affect the time profile of consumption and the trade balance. In particular it is shown that the presence of a home goods sector dampens the consumption effects of changes in the world interest rate.

A general equilibrium model of optimal employment contracts is developed where firms have better information about labor's marginal product than workers. It is optimal for the wage to be tied to the level of employment, to prevent the firm from falsely stating that the marginal product is low and cutting the wage. It is shown that an observed aggregate shock that leads to an interindustry shift in labor demand and that would have no effect on total employment under symmetric information leads to a reduction in employment when firms and workers have asymmetric information.