Dynamic effects of trade liberalization and currency overvaluation under conditions of increasing returns

Abstract

This paper examines the dynamic implications of a shift in relative prices between traded and nontraded goods. In accordance with empirical evidence the authors allow for sluggish wage adjustment and increasing returns to scale in the traded goods sector. The presence of increasing returns to scale gives rise to multiple equilibria, and trade liberalization and the associated short run changes in relative prices may leave the economy outside a 'corridor of stability' and lead to a cumulative process of contraction of the capital stock. Copyright 1998 by Blackwell Publishers Ltd and The Victoria University of Manchester