Are the traditional trade-exchange rate theorems relevant for developing countries facing entry costs in international markets?

This paper investigates the relevance of traditional trade-exchange rate theorems for developing countries facing sunk entry costs in international markets. Firstly, the theorems analysing pricing of tradable goods and the trade balance dynamics following exchange rate shocks are accounted for. Secondly, the sunk cost hysteresis model of foreign trade is described, including the possibility for hysteresis both at the microeconomic and macroeconomic level. Finally, the implications of sunk cost hysteresis for the predictions of the traditional trade-exchange rate theorems are discussed. This paper argues that the sunk cost model provides a microeconomic basis for trade dynamics that allows for non-linearities and regime switches, something often seen in empirical analysis. When it comes to policy, this paper argues in favour of context-specific policy interventions and against the one size fits all approach of structural adjustment programmes.