Commodity Prices and Labour Market Dynamics in Small Open Economies

We investigate the connection between commodity price shocks and unemployment in advanced resource-rich small open economies from an empirical and theoretical perspective. Shocks to commodity prices are shown to influence labour market conditions primarily through the real exchange rate contrasting sharply with the transmission of technology shocks which are typically argued to affect the economy by changing labour productivity. The empirical impact of commodity price shocks is obtained from estimating a panel vector autoregression; a positive price shock is found to be expansionary for the components of GDP, causes the real exchange rate to appreciate, and improves labour market conditions. For every one percent increase in commodity prices, our estimates suggest a one basis point decline in the unemployment rate and at its peak a 0.3% increase in unfilled vacancies. We then match the impulse responses to a commodity price shock from a small open economy model with net commodity exports and search and matching frictions in the labour market to these empirical responses. As in the data, an increase in commodity prices raises consumption demand in the small open economy and induces a real appreciation. Facing higher relative prices for their goods, non-commodity producing firms post additional job vacancies, causing the number of matches between firms and workers to rise. As a result, unemployment falls, even if employment in the commodity-producing sector is negligible. For commodity price shocks, there is little difference between the standard Diamond (1982), Mortensen (1982), and Pissarides (1985) approach of modelling search and matching frictions and the alternating offer bargaining model suggested by Hall and Milgrom (2008).