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Real Exchange Rate and Consumption Fluctuations following Trade Liberalization

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    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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    Paper provided by Stockholm School of Economics in its series SSE/EFI 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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    1. 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.
    2. Douglas Gollin, 2001. "Getting Income Shares Right," Department of Economics Working Papers 2001-11, Department of Economics, Williams College.
    3. Rebelo, Sérgio, 1995. "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," CEPR Discussion Papers 1220, C.E.P.R. Discussion Papers.
    4. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
    5. repec:taf:applec:v:28:y:1996:i:2:p:203-08 is not listed on IDEAS
    6. Hans-Werner Sinn & Michael Reutter, 2001. "The Minimum Inflation Rate for Euroland," NBER Working Papers 8085, National Bureau of Economic Research, Inc.
    7. Jose De Gregorio & Alberto Giovannini, 1993. "International Evidence on Tradables and Nontradable Inflation," NBER Working Papers 4438, National Bureau of Economic Research, Inc.
    8. Wayne E. Ferson & George M. Constantinides, 1991. "Habit Persistence and Durability in Aggregate Consumption: Empirical Tests," NBER Working Papers 3631, National Bureau of Economic Research, Inc.
    9. Rouwenhorst, K. Geert, 1991. "Time to build and aggregate fluctuations : A reconsideration," Journal of Monetary Economics, Elsevier, vol. 27(2), pages 241-254, April.
    10. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
    11. Petya Koeva Brooks, 2000. "The Facts About Time: To-Build," IMF Working Papers 00/138, International Monetary Fund.
    12. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
    13. Charles Engel, 1995. "Accounting for U.S. Real Exchange Rate Changes," NBER Working Papers 5394, National Bureau of Economic Research, Inc.
    14. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series WP-99-14, Federal Reserve Bank of Chicago.
    15. Asea, Patrick K & Corden, W Max, 1994. "The Balassa-Samuelson Model: An Overview," Review of International Economics, Wiley Blackwell, vol. 2(3), pages 191-200, October.
    16. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
    17. Patrick K. Asea, 1994. "The Balassa-Samuelson Model: An Overview," UCLA Economics Working Papers 710, UCLA Department of Economics.
    18. Petya Koeva Brooks, 2001. "Time-To-Build and Convex Adjustment Costs," IMF Working Papers 01/9, International Monetary Fund.
    19. Lawrence J. Christiano & Richard M. Todd, 1996. "Time to plan and aggregate fluctuations," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-27.
    20. Peeters, Marga, 1996. "Investment gestation lags: The difference between time-to-build and delivery lags," MPRA Paper 28549, University Library of Munich, Germany.
    21. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
    22. Eberly, Janice C., 1997. "International evidence on investment and fundamentals," European Economic Review, Elsevier, vol. 41(6), pages 1055-1078, June.
    23. Caroline M. Betts & Timothy J. Kehoe, 2008. "Real Exchange Rate Movements and the Relative Price of Non-traded Goods," NBER Working Papers 14437, National Bureau of Economic Research, Inc.
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