freely mobile across all sectors. Tertiary-skilled labor is also fully mobile. In contrast, markets for low- and medium-skilled labor are segmented into farm- and non-farm categories. Within each segment, labor is perfectly mobile across activities (e.g., from bananas to coffee in agriculture), but mobility across segments is limited by a finite inter-segment migration elasticity.<sup>20</sup> The initial level of migration is set at 1 percent of the farm sector labor force, a level broadly consistent with the historical rates of rural-to-urban migration in Honduras reported in WDI for the period 1974– 2004. Although international migration is likely to be an important element in the dynamics of the Honduran labor market, it is not considered in this analysis due to the difficulties of modeling this flow in a single-country setting.

The version of the model used in this paper assumes no change in the degree of resource utilization, or fixed employment. On the one hand, this assumption is reasonable given that the official unemployment rate in Honduras has been fluctuating around four percent over the last five years. On the other hand, unofficial estimates place the unemployment rate as high as 28 percent, in which case the assumption of the unchanging unemployment rate could be more controversial. However, real wages in Honduras have been stable over the same period (Gindling and Terrell, 2006), which provides indirect evidence of significant labor market rigidities. In this case, unless we expect significant institutional improvements that make the Honduran labor market more competitive (not very likely given the historical performance of the economy, particularly in the business-as-usual scenario), the fixed unemployment rate assumption seems appropriate.

The volumes of government current and investment spending are fixed as shares of real GDP, while the deficit (in real terms) is also fixed. Public revenues adjust to clear the government balance by means of a flexible household direct tax rate. The shortfall between government investment demand and public saving is satisfied by a combination of domestic and foreign borrowing: domestic borrowing is a fixed share of the difference between public investment and public saving, while foreign borrowing makes up the residual. The total amount of foreign borrowing is limited by the restriction that foreign debt must remain a constant share of GDP throughout the model horizon, a restriction which implies that increases in foreign borrowing by the public sector crowd out private borrowing and private investment. Changes in the private capital stock are determined by the available quantity of private investment. Foreign direct investment, representing the majority of private capital flows from abroad, is exogenous and fixed as a share of real GDP. The investment-toGDP ratio is fixed at the base year value and a flexible marginal propensity to save out of household disposable income ensures that total saving equals total investment. The current account balance is fixed by the available quantity of foreign saving, and a flexible real exchange rate clears the balance of payments constraint.<sup>21</sup> The price of absorption is set as the num ́eraire.

The model is solved in a recursive dynamic mode, in which a sequence of end-of-period equilibria are linked with a set of equations that update the main macro variables. There are three determinants of real GDP growth in the model: labor supply growth, capital accumulation, and increases in productivity. The volumes of all three types of labor grow exogenously at the rate of growth of the working age population (ages 15-64), obtained from World Bank population forecasts.<sup>22</sup> The capital stock in each period is the sum of depreciated capital from the period before

> 20Note that the migration function is only specified in one direction and the level of migration is bounded from below by zero. In other words, no worker would migrate from non-farm to farm activities even if the agricultural wage surpassed the non-agricultural one.

> 21The balance of payments equation is redundant due to Walras’s Law and is dropped from the model specification.

> 22Note that this assumption ignores the recent efforts by the government of Honduras to scale up resources toward achieving the Millennium Development Goals, particularly the education target of reaching universal completion of primary school by 2015. Since almost 45 percent of the total population of Honduras is 16 years old or younger,

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