Inflation Dynamics in a Small Open Economy

We evaluate the empirical performance of forward‐looking models for inflation dynamics in a small open economy. Using likelihood‐based testing procedures, we find that the exact formulation is at odds with Norwegian data. Moreover, some of the parameters in the model are not well identified. We also find that the inexact formulation is not rejected statistically using a test based on a minimum distance method. However, confidence regions also reveal an identification problem with this model. Instead, we find a well‐specified backward‐looking model with imperfect competition underlying the price setting, which is a model that outperforms an alternative forward‐looking model in‐sample. The backward‐looking model also forecasts somewhat better than the alternative forward‐looking model, during and after the recent financial crisis.     

Terms‐of‐Trade Shocks and Exchange Rate Regimes in a Small Open Economy*

We examine the impact of terms‐of‐trade shocks on key macroeconomic variables by numerically solving a dynamic stochastic general equilibrium model of a small open economy. The model considers nominal price rigidity under different exchange rate regimes. The numerical solutions obtained are consistent with the empirical regularities documented by Broda (2004), in which output responses to shocks are smoother in floats than in pegs; in moving from pegs to floats, the rise in nominal exchange rate volatility is coupled by the rise in real exchange rate volatility; and in both exchange rate regimes, net foreign assets is the most volatile variable.     

Industrialization and Expectations in a Small Open Economy

The degree of industrialization in a country can be measured by the diversity of intermediate goods produced in the country. I construct a small-country model in which this diversity is determined endogenously in the process of industrialization. My model shows that the character istics of equilibria depend on the substitutability among intermediate goods; particularly when the substitutability is large, there may be multiple equilibria. When such equilibria exist, optimistic expectations lead to a high degree of industrialization but pessimistic expectations yield a low degree of industrialization.
JEL Classification Numbers: O14, F43, F12     

Correcting Trade Distortions in a Small Open Economy

This paper considers the second-best strategy of correcting a wide variety of trade distortions in a small open economy with perfect competition in all markets. Using the tools of duality, we obtain some general properties of the structure and the levels of the optimal taxlsubsidy rates. The paper also analyzes the welfare effects of unilateral piecemeal trade policy reforms when some of the quota distortions—imposed by the foreign countries—are unalterable. It is shown that the merits of unilateral trade policy reforms that are emphasized in the literature crucially depend on the absence of unalterable foreign imposed quotas.     

Growth and the Current Account in a Small Open Economy

The authors provide a framework with which to analyze growth in a small economy with perfect capital mobility. The framework provides a diagrammatic representation of steady states that differs in interesting and important ways from the usual closed-economy Solow-Swan diagram. The authors use the key diagrams to illustrate the effects of changes in parameters such as the saving rate and productivity growth on steady-state values of macroeconomic aggregates. They compare the steady-state results for the open economy with those obtained using the more familiar closed-economy model. They illustrate the possibility of endogenous income growth.     

Some Implications of Uncertainty in a Small Open Economy

Consider a small open economy which produces two commodities, the first a consumers' good and the second a producers' good, by means of a conventional no-joint-products technology. Suppose that one of the two production functions is subject to a random multiplicative disturbance and that factors of production must be allocated to the two industries before the realization of the random variable. It is known that if in the absence of uncertainty production is incompletely specialized then the same is true under uncertainty although the average output of the uncertain industry is lower. In the present paper we suppose that each of the two production functions is subject to a random multiplicative disturbance but restrict our attention to three particular cases: the polar cases of perfect correlation, positive and negative, and the intermediate case of zero correlation. It is shown that in none of these cases does there exist an obvious and complete analogue of the above proposition but that in each case something definite can be said, either about the possibility of complete specialization under uncertainty or about the effect of uncertainty on the allocation of factors (but not about both).     

Catching-up and Regulation in a Two-Sector Small Open Economy

Deregulation is often aimed at reducing mark-up pricing in technologically stagnant sheltered sectors. The paper shows that this may decrease the process of catching-up and welfare since it shifts resources away from R&D-intensive tradables sectors. Catching-up and deregulation are analyzed in an R&D-based growth model that allows for international capital mobility, trade, and spillovers. Knowledge spillovers raise the productivity of R&D in the exposed sector which results in catching-up. In the long run, the economy grows at the exogenous world growth rate. Capital mobility speeds up convergence. Temporary shocks have long-lasting effects as the economy exhibits hysteresis.     

Capital Accumulation and Convergence in a Small Open Economy

Outward‐oriented economies seem to grow faster than inward‐looking ones. Does the literature on convergence have anything to say on this? In the dynamic Heckscher–Ohlin–Samuelson model, with factor‐price equalization, there is no convergence of incomes. This is because with identical preferences and return to capital, irrespective of initial levels, the growth rates of consumption are the same. In the specific factors' model, there is factor‐price equalization in the long run, but incomes depend on endowments of non‐accumulable factors. Different specifications for the intersectorally mobile factors have different implications for development (as well as convergence).     

Protection and Exchange Rates in a Small Open Economy

In a small‐open‐economy model with two tradables and one nontradable, if a price index of these three goods is stabilized and the exchange rate is flexible, conditions are obtained in the cases of two and of three or more factors for an export subsidy or an import tariff to result in currency appreciation. In the case of three or more factors, conditions are obtained under which either an export‐subsidy or an import‐tariff policy (or a combination) can take the place of a flexible exchange rate in accommodating the necessary resource allocation to an exogenous capital outflow, generalizing Keynes’s 1931 proposition.     

Privatization in a Small Open Economy with Imperfect Competition

We look at privatization in a general equilibrium model of a small, tariff‐distorted, open economy. There is a differentiated good produced by both private and public sector enterprises. A reduction in government production in order to cut losses from such production raises the returns to capital and increases the tariff revenue, which are welfare‐improving. However, privatization also leads to lower wages and possibly fewer private brands. This lowers workers’ welfare, which may make privatization politically infeasible. Privatization can improve workers’ welfare with complementary reforms, e.g., attracting foreign investment or trade liberalization.     

Monetary Policy Rules for a Small Open Economy

In this paper, the optimal choice of a monetary target is investigated for a small open economy that is subject to foreign monetary policy shocks. In contrast to large parts of the literature, pegging the exchange rate is never the best policy choice for the small open economy in our model. Instead, monetary targeting and, depending on the parameter combination, producer price index targeting come closest to the optimal policy rule in terms of welfare. Generally, the welfare performance of the simple targeting rules under consideration hinge critically on the degree of pass-through in the home economy and in the rest of the world.     

The Dynamics of Temporary Policies in a Small Open Economy

The paper corrects a subtle, but crucial, conceptual flaw in a solution procedure initially proposed in 1990 by Sen and Turnovsky to analyze anticipated regime changes in small open economies based on the intertemporal optimization of rational forward–looking agents. The problem is its failure to consider the intertemporal solvency of the economy consistently. The paper focuses on temporary shocks, although the procedure also applies to announced future permanent policy changes. Since the issue is generic and relevant to a large class of policy changes, it is important for the intertemporal solvency aspect to be incorporated consistently. The authors show that the seriousness of the error in the previous solution procedure depends upon the specific shock, and two contrasting examples are discussed.     

Intertemporal Solvency in the Small Open Economy of Australia

This paper employs cointegration and multicointegration analysis to explore the issue of external solvency in the small open economy of Australia. Results indicate that in the fixed exchangerate era exports and imports are multicointegrated while in the more recent floating exchange-rate period the series do not share a conventional long-run equilibrium relationship. The results are consistent with intertemporal external solvency in the early period and insolvency more recently. Sustainability criteria are reviewed. Indications are that low saving and investment rates may inhibit Australia's abiliry to sustain persistent external imbalances, however, recent fiscal adjustments may work to abate this problem.     

Capital and Consumption Tax Reforms in a Small Open Economy

The effects of a reform in capital and consumption taxes on private welfare and government tax revenue are examined for a small open, capital‐importing economy. A trade‐off between private welfare and tax revenue is encountered in maximizing social welfare. Nonetheless, lowering capital taxes and raising consumption taxes can increase both private welfare and tax revenue if the initial tax rates are not optimal. In addition, a tax reform by this fashion is a likely response to a rise in the foreign rate of return on capital.     

Social Comparisons and Optimal Taxation in a Small Open Economy

In this paper, we analyze how international capital mobility affects the optimal labor and capital income tax policy in a small open economy when consumers care about relative consumption. The main results crucially depend on whether the government can tax returns on savings abroad. If the government can use flexible residence‐based capital income taxes, then the optimal policy rules from a closed economy largely carry over to the case of a small open economy. If it cannot, then capital income taxes become completely ineffective. The labor income taxes must then indirectly also reflect the corrective purpose that the absent capital income tax would have had.     

External Debt and Taylor Rules in a Small Open Economy

We develop a dynamic stochastic general equilibrium model of a small open economy in which both price rigidity and financial friction exist. We compare two cases featuring different interest rate rules. Both cases use the standard Taylor‐type interest rate rules, but the second case also considers external debt levels. We find that when friction in foreign borrowing is large, adding an external debt level to Taylor rules improves welfare. The welfare curve, however, exhibits a hump shape because excessive reactions to changes in external debt reduce welfare.     

Capital Inflows,Dutch Disease Effects,and Monetary Policy in a Small Open Economy

This paper studies the role of monetary policy in a small open economy that experiences Dutch disease effects as a result of capital inflows, and examines the issue of whether such a policy should seek to address these effects from a welfare perspective. I find that Dutch disease effects occur under a fixed nominal exchange rate regime. However, a monetary policy regime characterized by generalized Taylor interest rate rules featuring either the real exchange rate or the nominal exchange rate avert Dutch disease effects. Welfare results reveal that the optimal rule is a generalized Taylor rule consistent with nominal exchange rate flexibility.     

Income Taxation Rules and Stability of a Small Open Economy

This paper examines the stability of a small open economy under alternative income taxation rules. Using a one-sector real business cycle model with external increasing returns, we show that if the income tax schedule is linear, the small open economy will not generate equilibrium indeterminacy, but it exhibits a diverging behavior under certain conditions. In this case, an appropriate choice of nonlinear tax on the factor income may recover the saddle-point stability. We also reveal that if the taxation on the interest income on financial assets is regressive, then the small open economy may exhibit equilibrium indeterminacy. In this situation, a progressive tax rule on the interest income can contribute to eliminating sunspot-driven fluctuations.     

A Structural Model of Australia as a Small Open Economy

This paper sets up and estimates a structural model of Australia as a small open economy using Bayesian techniques. Unlike other recent studies, the paper shows that a small micro-founded model can capture the open economy dimensions quite well. Specifically, the model attributes a substantial fraction of the volatility of domestic output and inflation to foreign disturbances, close to what is suggested by unrestricted VAR studies. The paper also investigates the effects of various exogenous shocks on the Australian economy.