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Real Exchange Rate and Consumption Fluctuations following Trade Liberalization

Author

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  • Jönsson, Kristian

    () (Research Department, Central Bank of Sweden)

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.

Suggested Citation

  • Jönsson, Kristian, 2005. "Real Exchange Rate and Consumption Fluctuations following Trade Liberalization," Working Paper Series 187, Sveriges Riksbank (Central Bank of Sweden).
  • Handle: RePEc:hhs:rbnkwp:0187
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    File URL: http://www.riksbank.com/upload/Dokument_riksbank/Kat_foa/WP_187.pdf
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    References listed on IDEAS

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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.
    2. Choi, Yoonseok & Kim, Sunghyun, 2016. "Dynamic scoring of tax reforms in a small open economy model," Economic Modelling, Elsevier, vol. 58(C), pages 182-193.

    More about this item

    Keywords

    Non-traded goods; Balassa-Samuelsson; Time-to-build; Habit formation; Dynamic general equilibrium;

    JEL classification:

    • C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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