Trade Liberalization, Macroeconomic Adjustment, and Welfare: How Costly Are Nominal Rigidities?

Abstract

It has long been argued that the presence of nominal rigidities could cause adverse macroeconomic adjustment to trade liberalization and thus reduce the benefits of freer trade. The paper explores the welfare cost of macroeconomic adjustment within the framework of new open economy macroeconomic models. The welfare effect of trade liberalization is decomposed into a steady-state efficiency gain and a transitional loss associated with wage-price stickiness and is estimated for a wide range of parameter values. The paper finds that while the transitional loss can be a substantial proportion of steady-state gains under fixed exchange rates, it is relatively small under a flexible exchange rate regime supported by a simple Taylor-type rule.