Real Exchange Rate and Consumption Fluctuations following Trade Liberalization

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 investigates some possible 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 e¤ects of relative productivity growth in the traded sector along the lines of BalassaSamuelson, of time-to-build, and of habit formation in preferences. The analysis shows that a calibrated version of the augmented model can account for more of the price-consumption dynamics after trade liberalization than a benchmark two-sector model, without losing explanatory power for other real variables in the Spanish economy after 1986. I want to thank my advisor Lars Ljungqvist for many helpful discussions. I have also bene…tted from comments from Timothy J. Kehoe, Martin Flodén, Kim Ruhl and seminar participants at the NYU Macro Lunch Student Seminar. Financial support from Jan Wallander’s and Tom Hedelius’Foundation is gratefully acknowledged.