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Real Exchange Rate and Consumption Fluctuations following Trade Liberalization

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  • Jönsson, Kristian

    ()
    (Research Department, Central Bank of Sweden)

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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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    Bibliographic Info

    Paper provided by Sveriges Riksbank (Central Bank of Sweden) in its series Working Paper Series with number 187.

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    Length: 45 pages
    Date of creation: 01 Jul 2005
    Date of revision:
    Handle: RePEc:hhs:rbnkwp:0187

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    Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
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    Keywords: Non-traded goods; Balassa-Samuelsson; Time-to-build; Habit formation; Dynamic general equilibrium;

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    References

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    25. Patrick K. Asea, 1994. "The Balassa-Samuelson Model: An Overview," UCLA Economics Working Papers, UCLA Department of Economics 710, UCLA Department of Economics.
    26. 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, Elsevier, vol. 92(1), pages 198-209.

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