Testing for short-run money neutrality in a small open economy: The case of Canada

This paper adopts an econometric methodology which is based on standard nested-hypotheses testing in order to test the policy ineffectiveness proposition in the context of the Canadian economy. It thus avoids some problems associated with the non-nested hypotheses framework used by Barro and numerous other writers. The substantial openness of the Canadian economy is taken into account through the use of a Mundell-Flemming aggregate demand side. The supply response of the economy is carefully modelled, in the same context, and the familiar Sargent-Wallace aggregate supply function is derived as a special case of a more general Keynesian function — by assuming instantaneous adjustment of prices to costs. Empirical tests based on a data sample spanning the period of Canada's recent experience with flexible exchange rates are unfavorable to the policy ineffectiveness proposition.     

Budget consolidation in a small open economy: a case study for Slovenia

In this article, we use the macroeconometric model SLOPOL10 to calculate simulations of the development of the Slovenian economy until 2030. Starting from the present favourable prospects of the European economies, the forecast is very optimistic but it can nevertheless be improved by optimal fiscal policies as calculated using the OPTCON2 algorithm. If a negative shock to world trade of a size comparable to the Great Recession occurs, it will entail a decline in GDP and a slow recovery. In this case, optimal fiscal policies should not act in an expansionary way as the effectiveness of fiscal policy with respect to output and employment is rather limited in a small open economy like Slovenia. Instead, the goal of budget consolidation will call for a more restrictive fiscal policy, at least if the shock is temporary.     

Bayesian estimation of the output gap for a small open economy: The case of Canada

We introduce a novel approach for estimating output gaps for small open economies. Identification is based on a multivariate trend-cycle decomposition in which transitory exchange rate movements are linked to the output gap and inflation. The model is then applied to Canadian data.     

The effects of monetary policy in a small open economy: the case of Portugal

In this article, I analyse the macroeconomic effects of monetary policy on the Portuguese economy. I show that a positive interest rate shock leads to: (i) a contraction of real GDP and a substantial increase of the unemployment rate; (ii) a quick fall in the commodity price and a gradual decrease of the price level and (iii) a downward correction of the stock price index. It also produces a ‘short-lived liquidity effect’ and helps explain the negative comovement between bonds and stocks. In addition, I find evidence suggesting the existence of a money demand function characterized by small output and interest rate elasticities. By its turn, the central bank’s policy rule follows closely the dynamics of the money markets. Finally, both the real GDP and the price level in Portugal would have been higher during almost the entire sample period if there were no monetary policy surprises.     

Exchange rate pass-through in a small open economy: the Anglo-Irish case

Bilateral import unit values are constructed to investigate the extent and speed of exchange rate and production cost pass-through into the unit values of Irish imports (total and sectoral) from the UK using Menon's (1996 Menon, J. 1996. The degree and determinants of exchange rate pass-through: market structure, non-tariff barriers and multinational corporations. Economic Journal, 106(435): 434–44.  ) mark-up model. The approach used to measure exchange rate pass-through is based on cointegration and error-correction modelling and the period of analysis is from 1979 to 1995. Full pass-through from the bilateral Irish pound–Sterling exchange rate and from UK producer costs could not be rejected for total and sectoral import unit values for the sample period 1979q1–1995q4. This implies no role for domestic competing prices in explaining the long-run relationship determining unit values of Irish imports from the UK. The results indicate that for aggregate and sectoral unit values of Irish imports from the UK pass-through is incomplete in the short-run.     

The energy problem in a small open economy

The paper deals with the economic consequences of an oil price shock in a small open economy. The analysis along neoclassical lines is based upon a three-factor nested CES production function. The model takes account of capital accumulation. Analytical solutions for the short- and long-run are presented for a linearized version of the original model, which makes existing results more tractable.     

Optimal monetary policy for a small open economy

This paper focuses on the design of monetary policy rules for a small open economy. The model features optimizing behavior, general equilibrium and price stickiness. The real exchange rate is shown to affect the firm's real marginal cost, aggregate supply and aggregate demand. The welfare objective depends on the openness of the economy, and the optimal policy rule differs from that which obtains in a closed economy. The inflation versus output gap stabilization trade-off is caused by the real exchange rate. The implied optimal monetary policy regime is domestic inflation target coupled with controlled floating of the real exchange rate.     

Crowding out in an inflationary open economy: The Italian case

In an inflationary open economy model we can predict that if the system is stable, money financed public deficits determine a long-run expansion in output while bond financed deficits show ambiguous long-term effects on output. With short-term bond financing, local stability is logically consistent with crowding out. Some empirical simulations on the Italian inflationary open economy indicate that a sustained increase in public consumption financed by short-run bonds induces a long-run convergent tendency to crowding out.     

The determinants of international reserves in the small open economy: The case of Honduras

The strong monetary approach to the balance of payments suggests that for a small open economy with a fixed exchange rate, international-reserve losses are due to money-supply growth in excess of growth in money demand, where money demand is assumed to be a stable function of exogenously given income and world prices. This paper tests the applicability of the strong monetary approach to Honduras during the period 1960–1983. Although the strong monetary approach provides a statistical explanation of reserve movements during this period, insights into the underlying causes of reserve changes can be obtained through recognition of the importance of the income terms of trade in determining both real income and domestic-credit growth in the small open economy.     

Impact of economic uncertainty in a small open economy: the case of Chile

We construct the first news-based economic uncertainty index for Chile, which allowed us to rebuild 23 years of the history of economic uncertainty in the country and quantify its impact on the economy. We find that an increase in economic uncertainty conveys a fall in GDP, investment, and employment, even after accounting for the small open economy nature of Chile. In contrast to previous studies for big and developed economies, we do not find evidence of an overshooting effect when uncertainty dissipates; therefore, increases in economic uncertainty have negative effects on the economy, even in the long-run. Our estimates suggest that these impacts range from 10% to 20% for aggregate investment, 2.5% to 5% for GDP, and 1.3% to 4.2% for employment. Extensions suggest that economic uncertainty affects both mining and non-mining investment, with the former showing a more pronounced decline. We also find that the bulk of effect of economic uncertainty on aggregate investment is via private investment, with some short-run impacts on public investment. Moreover, compared to the GDP response, aggregate consumption responds in almost the same way to an economic uncertainty shock.     

The equity premium in a small open economy and an application to Israel

We show that the preferences suggested by Greenwood, Hercowitz and Huffman (GHH), which are quite common in real business cycle (RBC) models of small open economies, are not suited for reproducing both the business cycle and the equity premium facts of a small open economy. We show that by assuming a moderate degree of a wealth effect on labor supply, together with some limitations on labor supply (in the form of real wage rigidity), we can increase the volatility of the stochastic discount factor (SDF), thereby increasing the equity premium and improving the fit of the business cycle moments. We also find that under the aforementioned assumptions, a shock to the realized return on foreign bonds can help in reproducing the equity premium.     

A middle income trap in a small open economy: Modeling the Argentinean case

This paper presents a model of the conditions that may lead a small open economy towards a middle income trap. This situation has shown to be pervasive in Latin America. As Argentina is a salient instance of this phenomenon, we develop a stylized model of its economy at the first decades of the XXth century. It consists of a general equilibrium model of an open emerging economy, which is a price-taking primary goods exporter. A growth process is triggered by an increase of commodity prices, due to an upward jump of the world demand of these goods. The economy goes through several phases of growth, starting from a subsistence stage. Once decreasing returns set in, the economy reaches a steady state. Only a sustained high demand of its export products allows the economy to thrive. Otherwise, the economy gets entrapped in a middle income level.     

The relationship between exchange rates and interest rates in a small open emerging economy: The case of Romania

This paper revisits the relationship between interest rates and exchange rates in a small open emerging economy using wavelet-based methodologies. Based on data for Romania, our results confirm the theoretical predictions on the interest rate - exchange rate relationship during turmoil or policy changes. In the short term, the relationship is negative, confirming the sticky-price models, and over the long term, the relationship is positive, confirming the Purchasing Power Parity theory. At the beginning of the turmoil, the exchange rate movements generally take the lead over the interest rates for the first month, but the monetary authorities take the lead afterwards. Our results reveal that in a small open emerging economy with a direct inflation targeting monetary policy regime, the relationship between exchange rates and interest rate is fundamentally different from that in an advanced economy. Also, our results stress the necessity that the central bank must pay simultaneous attention to both variables in order to achieve their monetary policy targets.     

Money and prices in an increasingly open economy: The case of Taiwan

The paper examines the price movement in an increasingly open economy like Taiwan. A theoretical model of the open-economy quantity theory is set forth which relates domestic inflation rate to inflation of world price, monetary expansion, and fluctuation of real income. The empirical evidence suggests that the relative importance of monetary changes in determining domestic price changes declines over time as the degree of openness of the economy rises over time.     

On the role of money in a business cycle model of a small open economy: The case of Spain

This paper examines the consequences of introducing a cash-in-advance constraint into a small open economy business cycle model for the Spanish case. A business cycle model is built extending Correia, Neves and Rebelo's (1995) small open economy framework and Cooley and Hansen's (1995) monetary economy. Money is introduced through a cash-in-advance constraint. The stochastic simulation of the model and its comparison to Spanish data show that the model is able to mimic i) the Dolado et al. puzzle, that is, the high volatility of private consumption for this economy; ii) the Dunlop-Tarshis observation, i.e., the negative correlation between real wages and hours worked; and iii) some cyclical features of the nominal dimension.     

The dynamic effects of tax policies in a small open economy

We develop an intertemporal optimizing model of a small open economy with both durable and nondurable consumption to address the implications of alternative tax policies. An increase in lump sum taxes reduces the steady state level of consumption and improves the stock of foreign bonds. Consistent with empirical evidence, durable consumption exhibits initial excess volatility. Though an increase in the tax on durables increases the demand for nondurables and improves the bond holdings in the steady state, an increase in the tax on nondurables has insignificant effects on the stock of foreign bonds and the consumption of durables. Using quarterly data from the UK and estimating generalized impulse response functions we find empirical support. We also calibrate the welfare implications of different tax policies.     

Wage-setting coordination in a small open economy*

This paper studies wage-setting coordination in a two-sector, open economy dynamic stochastic general equilibrium model. Two large sectoral unions anticipate the effects of their wage demands on aggregate variables. In an open economy, there are externalities that the unions can take into account to increase aggregate welfare, but the strategic interaction between the sectoral unions tends to erode this gain. When wage coordination takes place through a wage norm set by either of the sectors, this minimizes the strategic interaction. However, wage norms create welfare losses as sector-specific wage adjustment is required to make an efficient adjustment to shocks.     

Aggregate supply management in a small open economy

For a closed economy a cut in either payroll or income taxes stimulates output, but they influence the price level in different directions. In a two-sector, small open economy these conclusions are much more tenuous. Using a model that maintains equilibrium in the only two purely domestic markets, labor and nontradeables, it is established that a payroll-tax cut increases the size of the labor force, but does not guarantee higher real income. For either tax cut, prices and output move in opposite directions. In the short run when wages are “sticky,” an income-tax cut has the undesirable effect of increasing unemployment. In the face of a supply shock that reduces demand for labor, a payroll-tax cut can reestablish the original equilibrium.     

Optimal oil taxation in a small open economy

The international oil market has been very volatile over the past three decades. In industrialized economies, especially in Europe, taxes represent a large fraction of oil prices and governments do not seem to react to oil price shocks by using oil taxes strategically. The aim of this paper is to analyze optimal oil taxation in a dynamic stochastic general equilibrium model of a small open economy that imports oil. We find that in general it is not optimal to distort the oil price paid by firms with taxes, neither in the long run nor over the business cycle. The general result could be reversed depending on environmental considerations and available fiscal instruments. We provide simulations to illustrate the optimal response to shocks in such cases.