This paper explores the consequences of introducing a monopolistic competition
in an intertemporal two-sector small open economy model which
produces traded and non traded goods. It is assumed that the non traded
sector is the locus of the imperfectly competition. Our analysis shows that
markup depends on the composition of aggregate non traded demand and
is therefore endogenously determined in the model. Calibrating the model
with OECD parameters, the effects of fiscal and technological shocks are
simulated. Our findings are as follows. First, the model is consistent with
the observed saving-investment correlations found in the data. Second,
unlike the perfectly framework and in accordance with empirical studies,
fiscal shocks cause real appreciation of the relative price of non traded
goods, which in turn enlarges the responses of current account and investment.
Third, the model is consistent with the empirical report that
technological shocks result in current account deficits and investment rises.
Fourth, the strength of the relative price appreciation following sector productivity
differentials, i.e. the Balassa-Samuelson effect, is affected by the
monopolistic competition hypothesis. Assume perfect competition when
it is not, biases upward estimates of the Balassa-Samuelson effect.