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Abstract.  The present paper uses a dynamic open‐economy model with wage indexation to examine the impact of tourism on employment and welfare. Both short‐run and long‐run situations are analysed. It is well known that tourism converts non‐traded goods into tradable goods. An increase in the demand for a non‐traded good raises its relative price, which results in an expansion of the non‐traded sector at the expense of the traded goods sector. This output shift raises labour employment in the short run. However, in the long run, the higher relative price leads to higher wages, resulting in a negative impact on labour employment. If the output effect is dominant, the expansion in tourism raises employment and welfare. However, under realistic conditions tourism may lower both labour employment and welfare due to rising costs. These results are demonstrated by simulating a dynamic model for the case of Hong Kong.