Real Effects of Nominal shocks: a 2-sector Dynamic Model with Slow Capital Adjustment and Money-in-the-utility

This paper develops a two-sector model to study the e.ect and incidence of nominal shocks (fiscal or exchange rate policies) on sectors and factors of production. I adopt a classical twosector model of a small open economy and enrich its structure with gradual investment and a preference for real money holdings. An expansive nominal shock (fiscal expansion or a nominal appreciation) leads to increased spending (due to the role of money), which pushes nontraded prices up (with gradual capital adjustment, the short-term transformation curve is nonlinear). This translates into changes in factor rewards, capital labor ratios and sector-level employment of capital and labor. Higher nontraded prices lead to extra domestic income, validating some of the initial excess spending. This propagation mechanism leads to a persistent real e.ect (on relative prices, factor rewards, capital accumulation) of nominal shocks, which disappears gradually through money outflow (trade deficit). I also draw parallels with the NATREX approach of equilibrium real exchange rates and the literature on exchange rate based stabilizations.