Abstract

This paper shows that developing countries possess an inherent shock-absorbing mechanism that stems from their peculiar institutional characteristics and can lessen the gravity of detrimental welfare consequence of exogenous terms-of-trade disturbances in terms of a two-sector, full-employment general equilibrium model with endogenous labour market distortion. The supply of foreign capital in the economy is a positive function of the return to capital and a decreasing function of the degree of prevailing restrictions in the economy in the process of free inflow of foreign capital. The analysis leads to a couple of important policies that should be adhered to preserve this in-built system. Finally, it offers three important statistically testable hypotheses, empirical validation of which might have an important bearing on formulation of developmental policies in these countries.