Policy Distortions, the Single Country General Equilibrium and the Two Country Trading Pattern

Abstract

This paper evaluates the effects of policy distortions under the single country closed economy and the two country open economies. I first study the effect of policy distortions on a single country general equilibrium in which production is carried out by heterogeneous firms under different policy distortions, i.e. with zero, random, negatively and positively correlated policy distortion respectively. I find that different tax policies that distort firms’ production can lead to sizable changes in equilibrium aggregate output, price level and the economy concentration. The tax policy that is in favor of more productive firms, i.e. negatively correlated tax policy, could increase the country’s aggregate production level substantially without causing an inflation or a monopoly power. I then study the effect of policy distortions on the two country general equilibrium by considering different policy distortions in both the home and the foreign countries. My results show that trading with a country which has the negatively correlated tax policy is beneficial to both countries and hence should be encouraged. By doing the counter-factual analysis, I also find that trading with a foreign country with a lower iceberg trading cost or a higher baseline production technology can benefit the home country and shall be encouraged.