Fiscal shocks in a two sector open economy with endogenous markups

We use a two-sector neoclassical open economy model with traded and non-traded goods and endogenous markups to investigate both the aggregate and the sectoral ef- fects of temporary fiscal shocks. One central finding is that both the sectoral capital intensities and endogenous markups matter in determining the response of key eco- nomic variables. In particular, the model can produce a drop in investment and in the current account, in line with empirical evidence, only if the traded sector is more capital intensive than the non-traded sector. Irrespective of sectoral capital intensities, a fiscal shock raises the relative size of the non-traded sector substantially in the short-run. Additionally, allowing for the markup to depend on the number of competitors, the two-sector model can account for the real exchange rate depreciation found in the data. Finally, markup variations triggered by firm entry can raise the real wage, albeit under certain circumstances, and modify substantially the sectoral composition of GDP in the short-run.