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

Abstract

In this paper we examine 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 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.