A Simple Model of the Transformational Recession Under a Limited Mobility Constraint

Abstract

This paper considers the impact on sectoral outputs and employments of rapid and large changes in relative prices, such as those which occurred in transition economies during the 1990s. A simple general equilibrium model is developed in which price changes are induced by a tax reform and resource mobility is restricted. The reform is designed to improve the quality of the price system, but is shown to cause a recession the size of which is proportional to the initial tax distortion. It is also demonstrated that a wage flexibility would moderate the magnitude of the recession, but this gain would be obtained at a cost in longer term efficiency, and would be, in any case, unsustainable.Output falls, Central Europe, Former Soviet Union, contractionary impact, relative prices, transition economies