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Real Exchange Rate and Consumption Fluctuations following Trade Liberalization

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  • Jönsson, Kristian

    ()
    (SVERIGES RIKSBANK, Research Department)

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    Abstract

    Two-sector models with traded and non-traded goods have problems accounting for the stylized fact that the real exchange rate appreciates and consumption booms for several years following trade liberalization, or exchange-rate-based stabilization programs, in small open economies. The paper studies three potential solutions to this 'price-consumption puzzle' and evaluates their quantitative importance in calibrated simulations of Spain's accession to the European Community in 1986. Extending the standard two-sector framework, the paper investigates the effects of relative productivity growth in the traded sector along the lines of Balassa-Samuelson, of time-to-build, and of habit formation in preferences. In contrast to previous studies, we find that habit formation on its own does not enable the model to account for the observed real exchange rate and consumption dynamics. The analysis shows that a calibrated version of the model augmented with all three mechanisms can account for much of the price-consumption dynamics after trade liberalization, without losing explanatory power for other real variables in the Spanish economy after 1986.

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    File URL: http://swopec.hhs.se/hastef/papers/hastef0568.pdf
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    Bibliographic Info

    Paper provided by Stockholm School of Economics in its series Working Paper Series in Economics and Finance with number 568.

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    Length: 40 pages
    Date of creation: 08 Nov 2004
    Date of revision: 04 Jan 2005
    Handle: RePEc:hhs:hastef:0568

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    Keywords: Two-sector models; Balassa-Samuelson; Time-to-build; Habit formation; Real exchange rate; Trade liberalization;

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    References

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    3. de Cordoba, Gonzalo Fernandez & Kehoe, Timothy J., 2000. "Capital flows and real exchange rate fluctuations following Spain's entry into the European Community," Journal of International Economics, Elsevier, vol. 51(1), pages 49-78, June.
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    8. Patrick K. Asea, 1994. "The Balassa-Samuelson Model: An Overview," UCLA Economics Working Papers 710, UCLA Department of Economics.
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    14. repec:taf:applec:v:28:y:1996:i:2:p:203-08 is not listed on IDEAS
    15. Peeters, Marga, 1996. "Investment gestation lags: The difference between time-to-build and delivery lags," MPRA Paper 28549, University Library of Munich, Germany.
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    Cited by:
    1. Kim, Sunghyun H. & Kose, M. Ayhan, 2014. "Welfare implications of trade liberalization and fiscal reform: A quantitative experiment," Journal of International Economics, Elsevier, vol. 92(1), pages 198-209.

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