Non-traded goods and optimal trade policy in a cash-in-advance economy

This paper develops a standard trade model of a small open monetary economy with two traded and one non-traded goods. Money is introduced through a generalized cash-in-advance constraint where the share of goods purchases that must be made using cash, varies across sectors. We find that free trade may be harmful so that alternative policy instruments may be considered to improve welfare. In addition, we study and compare the optimal tariff formula and the optimal consumption tax structure. In the presence of a monetary distortion of the non-traded good, a consumption tax may not Pareto dominate a tariff although the latter bears an additional production burden. This corroborates the theory of second best.