The Effects of Foreign Transfers with Flexible Labor Supply

We show that the importance of flexible labor supply in determining the impact of foreign transfers depends upon whether the transfers are untied or tied to productivity enhancement. This is because the transfer has both a wealth effect and a relative price effect, the relative importance of which depends upon its allocation. For an untied transfer, the relative price effect is weak, the wealth effect on leisure dominates, and the endogeneity of the labor supply is important. For a tied transfer, the increase in productivity raises the wage rate, thereby inducing an increase in aggregate labor supply and offsetting the increase in leisure due to the wealth effect. The overall response in leisure is small and is dominated by the relative price effect. In this case, given this small response, whether the aggregate labor is supplied elastically or is constrained to be fixed turns out to make little difference.