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Real Exchange Rate and Consumption Fluctuations following Trade Liberalization

  • Jönsson, Kristian


    (Research Department, Central Bank of Sweden)

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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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    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
    Contact details of provider: Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
    Phone: 08 - 787 00 00
    Fax: 08-21 05 31
    Web page:

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    1. Bems, Rudolfs & Jönsson, Kristian, 2005. "Trade Deficits in the Baltic States: How Long Will the Party Last?," Working Paper Series 186, Sveriges Riksbank (Central Bank of Sweden).
    2. De Gregorio, Jose & Giovannini, Alberto & Wolf, Holger C., 1994. "International evidence on tradables and nontradables inflation," European Economic Review, Elsevier, vol. 38(6), pages 1225-1244, June.
    3. Peeters, Marga, 1996. "Investment gestation lags: The difference between time-to-build and delivery lags," MPRA Paper 28549, University Library of Munich, Germany.
    4. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
    5. 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.
    6. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
    7. Caroline M. Betts & Timothy J. Kehoe, 2008. "Real exchange rate movements and the relative price of non-traded goods," Staff Report 415, Federal Reserve Bank of Minneapolis.
    8. 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.
    9. repec:taf:applec:v:28:y:1996:i:2:p:203-08 is not listed on IDEAS
    10. Douglas Gollin, 2002. "Getting Income Shares Right," Journal of Political Economy, University of Chicago Press, vol. 110(2), pages 458-474, April.
    11. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Closing Small Open Economy Models," Departmental Working Papers 200115, Rutgers University, Department of Economics.
    12. Ariel Burstein & Joao C. Neves & Sergio Rebelo, 2004. "Investment Prices and Exchange Rates: Some Basic Facts," NBER Working Papers 10238, National Bureau of Economic Research, Inc.
    13. Petya Koeva Brooks, 2001. "Time-To-Build and Convex Adjustment Costs," IMF Working Papers 01/9, International Monetary Fund.
    14. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
    15. Charles Engel, 1999. "Accounting for U.S. Real Exchange Rate Changes," Journal of Political Economy, University of Chicago Press, vol. 107(3), pages 507-538, June.
    16. Rebelo, S. & Vegh, C.A., 1995. "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," RCER Working Papers 405, University of Rochester - Center for Economic Research (RCER).
    17. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
    18. Eberly, Janice C., 1997. "International evidence on investment and fundamentals," European Economic Review, Elsevier, vol. 41(6), pages 1055-1078, June.
    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. Hans-Werner Sinn & Michael Reutter, 2001. "The Minimum Inflation Rate for Euroland," NBER Working Papers 8085, National Bureau of Economic Research, Inc.
    21. Rouwenhorst, K. Geert, 1991. "Time to build and aggregate fluctuations : A reconsideration," Journal of Monetary Economics, Elsevier, vol. 27(2), pages 241-254, April.
    22. 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.
    23. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
    24. Petya Koeva Brooks, 2000. "The Facts About Time: To-Build," IMF Working Papers 00/138, International Monetary Fund.
    25. Patrick K. Asea, 1994. "The Balassa-Samuelson Model: An Overview," UCLA Economics Working Papers 710, UCLA Department of Economics.
    26. 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.
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