Dynamic Effects of Trade Liberalization and Currency Overvaluation Under Conditions of Increasing Returns

This paper examines the dynamic implications of a shift in relative prices between traded and non-traded goods. In accordance with empirical evidence we allow for sluggish wage adjustment and the presence of increasing returns to scale in the traded goods sector. The existence of increasing returns to scale gives rise to the possibility of multiple equilibria, and with multiple equilibria trade liberalization and the associated short run changes in relative prices can have long-term, real consequences. It may leave the economy outside a quot;corridor of stabilityquot; and lead to a cumulative process of contraction of the capital stock. The likelihood of this happening increases in the case of radical and abrupt trade liberalization which is unaccompanied by currency devaluation. A number of trade liberalization experiences (including those of Chile from 1974 to 1982 and Mexico from 1988 to the present crisis) illustrate in practice the dangers highlighted by the model