Sectoral adjustment costs and real exchange rate dynamics in a two-sector dependent economy

Abstract

This paper develops a two-sector model in which intersectoral capital movements involve adjustment costs, expressed as capital lost in the transformation process. These costs have important consequences for the dynamics of capital accumulation and particularly for real exchange rate dynamics. Persistent deviations of the real exchange rate from its equilibrium are derived and for plausible values of the adjustment cost parameters are consistent with the observed degree of real exchange rate persistence. For low adjustment costs the dynamics are qualitatively similar to those of the standard Heckscher–Ohlin technology. For high adjustment costs, the model converges to the specific-factors model. Thus our framework includes these two standard models as polar extremes.