Abstract:
This paper develops a two-sector small open economy general equilibrium model. By assuming that rural labors need to pay idiosyncratic costs to get employed in the industrial sector, the paper articulates how technological advancement affects real exchange rate, sectoral wage gap and other endogenous variables in a dual economy, hereby providing a theoretical framework to understand related issues in dual economies such as China. We not only test certain testable predictions of the model using multi-country panel data, but simulate the model to assess its ability to fit Chinese data. It is shown that the model can account for the dynamics of all endogenous variables in the sample period strikingly well, particularly the seemingly weak but fast appreciating RMB-USD real exchange rate, as well as China's ever expanding industry-agriculture wage gap. In every aspect, the model significantly outperforms the classic frictionless Balassa-Samuelson model.
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