Fiscal Shocks in a Two-Sector Open Economy

We use a two-sector neoclassical open economy model with traded and non-traded goods to investigate both the aggregate and the sectoral effects of temporary fiscal shocks. One central finding is that both sectoral capital intensities and labor supply elasticity matter in determining the response of key economic 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, and labor is supplied elastically. 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 produce the real exchange rate depreciation found in the data. Finally, markup variations triggered by firm entry modify substantially the response of the real wage and the sectoral composition of GDP in the short-run.