Economic Booms, Trade Deficits, and Economic Policy

Abstract

Many economic booms have been accompanied by a real exchange rate appreciation, a large trade deficit and a deteriorating traded sector, and have raised the question of the desirability of some stabilization policy. We characterize the dynamics created by an expected productivity rise in an open economy where firms have limited access to financial markets. The shock raises the real exchange rate and creates a trade deficit. We show that this can bring the traded sector into losses, and that borrowing constraints may cause an inefficiently high capacity reduction in the traded sector, as well as larger trade deficits. Several economic policy alternatives are explored.