Demand Changes and Real Exchange Rate Dynamics in a Finite‐Horizon Model with Sectoral Adjustment Costs

Abstract

In this paper, we use the Blanchard‐type uncertain lifetime overlapping generations framework to develop a three‐good open economy to examine the effects of demand changes on the economic performance of small open economies with sectoral adjustment costs. Our simulation results reveal a discernible Harberger‐Laursen‐Metzler effect on both temporary and permanent terms‐of‐trade shocks. The inclusion of sectoral adjustment costs generates persistent deviations of the real exchange rate from its long‐run equilibrium in response to terms‐of‐trade shocks, with the degree of sectoral adjustment costs having an effect on the subsequent dynamic transition of the economy. We also find that an increase in the mortality rate leads to a lowering of the current account.