Over the last two decades numerous countries have implemented reform packages that sought to improve the efficiency of their economies. Trade reform, liberaliza-tion of capital flows, changes in tax legislation, improvements in the protection of property rights, and de-regulation of the financial intermediation sector, have been widely used to try to improve economic performance.
Every time these reforms are implemented agents debate the extent to which they are likely to be temporary or permanent. Why is this important? Calvo and Mendoza (1994) stress two reasons. The duration of the reform is relevant: (i) in determining the size of the wealth effect experienced by the private sector; and (ii) in setting in motion intertemporal substitution effects in reforms perceived as temporary. Both of these mechanisms affect consumption and labor supply decisions as well as the economy’s trade balance.
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In this paper we analyze a third mechanism through which the temporariness of the reform may have important consequences. Reforms tend to induce important sectoral reallocations of investment. If investment decisions are costly to reverse, the duration of the reform becomes a critical determinant of capital and labor reallocation, firm entry, and firm exit.
A model where investment is reversible and capital can be freely re-allocated across sectors predicts that trade reforms-even temporary ones-should have very large effects on investment and on the industrial configuration. These predictions stand in sharp contrast with the evidence collected in numerous case studies by Papageorgiou et al. (1990) and Helleiner (1994) which suggests that there is substantial inertia in the process of firm creation and firm destruction. To give two examples, Rayner and Lattimore (1991, page 119) summarize the effects of trade reform in New Zealand as follows: “The 40 years covered by this study of trade liberalization in New Zealand saw many changes, some gradual and some extraordinarily swift and even drastic. But beneath these surface movements the structure of the economy has been remarkably resistant to change’.