Essays in Open Economy Macroeconomics

This dissertation consists of three essays in open economy macroeconomics. The first essay examines how changes in inflation affect the size of the shadow economy. Previous studies show that lowering the tax rate and increasing the level of tax enforcement may reduce the size of the shadow economy. However, most developing countries are unable to effectively enforce their tax laws. This essay develops a two-sector general equilibrium model of a small open economy to show how monetary policy can be used to tackle the shadow economy problem. The result suggests that, conditional on access to formal credit, a rise in inflation leads to a reduction in the size of the shadow economy. The finding calls into question the preoccupation with pursuing single-digit inflation by developing countries, especially those with large informal sectors. The second essay explores the welfare implications of trade liberalization when revenue matters. Some empirical studies have shown that many developing economies were unable to recover lost trade revenue from domestic taxes after implementing trade liberalizing policies. Ignoring the fiscal cost of trade liberalization when government spending is not completely wasteful may lead to misleading welfare estimates. We address these concerns by developing a model in which government spending augments the production function, enabling it to account for the role of revenue and its impacts on welfare. The model is calibrated to capture the features of the Ghanaian economy. We find significant but lower welfare effects of trade liberalization when government spending on infrastructure plays an important role in the production process. The third essay investigates the macroeconomic effects of import competition. Recent trade literature demonstrates that import competition enhances domestic productivity and generates favorable terms of trade in the economy. The existing literature studies the issue at the micro level and focuses exclusively on the firm level. Though production and investment of the domestic economy are expected to increase, the effects on the current account are not so obvious. This paper shows that the economy will experience a deteriorated current account. The welfare effect is ambiguous.