Are the traditional trade-exchange rate theorems relevant for developing countries facing entry costs in international markets?

Abstract

This paper investigates the relevance of traditional trade-exchange rate theo- rem for developing countries facing sunk entry costs in international markets. First the theorems analysing pricing of tradable goods and the trade balance dynamics following exchange rate shocks are accounted for. Second the sunk cost hysteresis model of foreign trade is described, including the possibility for hysteresis both at the microeconomic and at the macroeconomic level. Third the implications of sunk cost hysteresis for the predictions of the traditional trade-exchange rate theorems are discussed, focusing on both pricing of trad- able goods as well as short and long run trade balance dynamics following exchange rate shocks. The paper argues that the sunk cost model provides a microeconomic basis for trade dynamics that allows for non-linearities and regime switches, something often seen in empirical anlysis. The predictions of structural adjustment programs are however drawn from the traditional theorems, lacking the possibility for non-linearity. The sunk cost model is argued to push both pricing rules and trade balance dynamics closer towards the empirical record, mainly by allowing for a state-dependent relationship between exchange rates and foreign trade. When it comes to policy implica- tions the paper argues in favour of context speci.c policy interventions and against the one size .ts all approach of structural adjustment programs.