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Abstract

In this paper we revisit the issue of aggregate output decline that took place in the early transition period. We propose an alternative explanation of output decline that is applicable to Central- and Eastern-European countries. In the first part of the paper we develop a simple dynamic general equilibrium model that builds on work by Gomulka and Lane (2001). In particular, we consider price liberalization, interpreted as elimination of distortionary taxation, as a trigger of the output decline. We show that price liberalization in interaction with heterogeneous adjustment costs and non-employment benefits lead to aggregate output decline and surge in wage inequality. While these patterns are consistent with actual dynamics in CEE countries, this model cannot generate output decline in all sectors. Instead sectors that were initially taxed even exhibit output growth. Thus, in the second part we consider an alternative general equilibrium model with only one production sector and two types of labor and distortion in a form of wage compression during the socialist era. The trigger for labor mobility and consequently output decline is wage liberalization. Assuming heterogeneity of workers in terms of adjustment costs and non-employment benefits can explain output decline in all industries.

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