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 e®ects of temporary ¯scal shocks. One central ¯nding 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 em- pirical 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 ¯s- cal 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 ¯rm entry modify substantially the response of the real wage and the sectoral composition of GDP in the short-run.