Optimal borrowing constraints and growth in a small open economy

Chinese high growth has been accompanied by government restrictions on international borrowing (capital controls). In this paper, we ask: are such restrictions a useful policy tool to facilitate growth? We provide a theory of borrowing constraints on households as a tool to correct a learning-by-doing externality. Borrowing constraints operate as a policy tool through two channels: (i) increasing labor supply and (ii) reallocating labor towards traded goods. We find that welfare gains are closest to that of the First-Best Planner allocation when the externality is not too large. We compute the sequence of optimal constraints along the growth path and show how the use of this policy tool contributes to repressed wages, current account balance, and slow real exchange rate appreciation.     

Optimal fiscal policy in a small open economy with limited commitment

We introduce limited commitment into a standard optimal fiscal policy model in small open economies. We consider the problem of a benevolent government that signs a risk-sharing contract with the rest of the world, and that has to choose optimally distortionary taxes on labor income, domestic debt and international transfers. Both the home country and the rest of the world may have limited commitment, which means that they can leave the contract if they find it convenient. The contract is designed so that, at any point in time, neither party has incentives to exit. We define a small open emerging economy as an economy where the limited commitment problem is active in equilibrium. Conversely, a small open developed economy is an economy in which the commitment problem is not active. Our model is able to rationalize some stylized facts about fiscal policy in emerging economies: i) the volatility of tax revenues over GDP is higher in emerging economies than in developed ones; ii) fiscal policy is procyclical in emerging economies; iii) emerging economies may “graduate” from procyclical fiscal policy and adopt countercyclical policies in the long run.     

Monetary policy and welfare in a small open economy

This paper analyzes optimal monetary policy in a small open economy featuring monopolistic competition and nominal rigidities. It shows that the utility-based loss function for this economy can be written as a quadratic expression of domestic inflation, output gap and real exchange rate. The presence of an internal monopolistic distortion and a terms of trade externality drives optimal policy away from domestic inflation targeting and affects the optimal level of exchange rate volatility. When domestic and foreign goods are close substitutes for each other, the optimal policy rule implies lower real exchange rate volatility than a domestic inflation targeting regime. The reverse is true when the elasticity of substitution between goods is low.     

The yield curve in a small open economy

Long-term nominal interest rates in a number of inflation-targeting small open economies have tended to be strongly correlated with those of the United States. This observation has recently led support to the view that, in these economies, the long-end of the yield curve has decoupled from its short-end and naturally to a concern that monetary policy may have lost some of its autonomy. We set up and estimate a two-country small open economy model in which the expectations hypothesis and uncovered interest rate parity hold to study the co-movement of long-term nominal interest rates of different currencies. We show that differences in the persistence of domestic and foreign disturbances, a hypothesis for which we find support in recent data, can explain the observed pattern of correlations. These correlations are not evidence of weaker monetary policy.     

The yield curve in a small open economy

Long-term nominal interest rates in a number of inflation-targeting small open economies have tended to be strongly correlated with those of the United States. This observation has recently led support to the view that, in these economies, the long-end of the yield curve has decoupled from its short-end and naturally to a concern that monetary policy may have lost some of its autonomy. We set up and estimate a two-country small open economy model in which the expectations hypothesis and uncovered interest rate parity hold to study the co-movement of long-term nominal interest rates of different currencies. We show that differences in the persistence of domestic and foreign disturbances, a hypothesis for which we find support in recent data, can explain the observed pattern of correlations. These correlations are not evidence of weaker monetary policy.     

Trade liberalization, product variety and growth in a small open economy: a quantitative assessment

We develop a numerical growth model that quantifies the welfare effects of trade liberalization. Additional intermediate input varieties provide the engine of growth and dramatically magnify the welfare gains from trade liberalization. In our central model, a 10% tariff cut leads to a 10.6% estimated gain in Hicksian EV. Systematic sensitivity analysis shows that there is virtually no chance of a welfare increase less than 3%, but a 6.6% chance of a welfare gain greater than 18%. We show that complementary reforms are crucial to fully realize the potential gains from the trade reform.     

Closing small open economy models

The small open economy model with incomplete asset markets features a steady-state that depends on initial conditions and equilibrium dynamics that possess a random walk component. A number of modifications to the standard model have been proposed to induce stationarity. This paper presents a quantitative comparison of these alternative approaches. Five different specifications are considered: (1) A model with an endogenous discount factor (Uzawa-type preferences); (2) a model with a debt-elastic interest-rate premium; (3) a model with convex portfolio adjustment costs; (4) a model with complete asset markets; and (5) a model without stationarity-inducing features. The main finding of the paper is that all models deliver virtually identical dynamics at business-cycle frequencies, as measured by unconditional second moments and impulse response functions. The only noticeable difference among the alternative specifications is that the complete-asset-market model induces smoother consumption dynamics.     

Public inputs and land taxes in a small open economy

In this paper we examine the issues of gains from trade and the welfare effects of trade policies in the presence of public inputs. Based on the formulation of Negishi (Journal of Public Economics 2 (1973), 231–40), we assume that public inputs are financed by a land tax scheme. We show that the welfare effects of trade policies and the desirability of trade depend crucially on the rules of public input provision reflecting different conjectures of the government.     

Raw materials price and technological uncertainty in a small open economy

This paper examines the implications of raw materials price uncertainty for capital allocation and compares the impact of production uncertainty and raw materials price uncertainty. It shows that the economy may avoid risk by allocating more capital in a sector using an input (for example, raw materials) which has a random price. This contrasts with multiplicative production uncertainty case, in which the economy avoids risk by allocating less capital to the risky (uncertainty) sector. Input efficiency uncertainty and materials input price uncertainty have the same implications for a raw-materials-importing economy, but quite opposite implications for a raw-materials-exporting economy.     

Optimal hedging under nonlinear borrowing cost,progressive tax rates,and liquidity constraints

Empirical research using optimal hedge ratios usually suggests that producers should hedge much more than they do. In this study, a new theoretical model of hedging is derived. Optimal hedge and leverage ratios and their relationship with yield risk, price variability, basis risk, taxes, and financial risk are determined using alternative assumptions. The motivation to hedge is provided by progressive tax rates and cost of bankruptcy. An empirical example for a wheat and stocker‐steer producer is provided. Results show that there are many factors, often assumed away in the literature, that make farmers hedge little or not at all. Progressive tax rates provide an incentive for farmers to hedge in order to reduce their tax liabilities and increase their after‐tax income. Farmers will hedge when the cost of hedging is less than the benefits of hedging that come from reducing tax liabilities, liquidity costs, or bankruptcy costs. When tax‐loss carryback is allowed, hedging decreases as the amount of tax loss that can be carried back increases. Higher profitability makes benefits from futures trading negligible and hedging unattractive, since farmers move to higher income brackets with near constant marginal tax rates. Increasing basis risk or yield risk also reduce the incentive to hedge. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20: 375–396, 2000     

Short-term and long-term interest rates in a monetary model of a small open economy

This paper analyzes the effects of both anticipated and unanticipated monetary and fiscal disturbances on the dynamic behavior of a monetary model of a small open economy. It focuses on the adjustment of the short-term and long-term interest rates and the divergence of their transitional paths, particularly in anticipation of these disturbances. The analysis demonstrates how anticipation of a future policy change can generate perverse short-run behavior. The essential reason for the divergence between the short and long rates is that the latter is dominated by long-term expectations, while the former is primarily determined by current influences.     

Industrial research and development and real exchange rate depreciation in a small open economy

To examine how changes in relative national prices affect innovation input, this paper studies the impact of changes in industry-specific effective real exchange rates on industrial R&D expenditures in Korea. In particular, it explores the heterogeneous responses of industries with different export intensities. Employing dynamic panel data estimation techniques, the results suggest that among industries with medium levels of export intensity a lagged depreciation in industry-specific effective real exchange rate leads to a decline in contemporaneous industry-level R&D expenditures. However, this adverse effect is insignificant for industries that either mostly serve the domestic markets or that are heavily engaged in foreign markets.     

Context in international business: Entrepreneurial internationalization from a distant small open economy

Context matters in International Business, but to what extent does it influence the content of knowledge? This study offers a systematic literature review on the internationalization of New Zealand firms. A geographically isolated small open economy (SMOPEC) with audacious trade aspirations, a strong domestic institutional environment, favorable attitude toward trade, and entrepreneurial small-to-medium size enterprises (SMEs), New Zealand provides an enlightening context to study internationalization. Using a sample of 95 studies, the review identifies antecedents, stimuli, capabilities, strategy, process and outcomes underpinning internationalizing New Zealand firms (INZFs). Context matters but not in the manner anticipated. On one hand research on the internationalization of New Zealand firms is largely congruent with extant knowledge, on the other the New Zealand context shapes uniquely, how and what scholars choose to research.     

Savings and the terms of trade under borrowing constraints

This paper examines the extent to which permanent terms of trade shocks have an asymmetric effect on private savings. The first part uses a simple three-period model to show that, if households expect to face binding borrowing constraints in bad states of nature, savings rates will respond asymmetrically to favorable movements in the permanent component of the terms of trade—in contrast to what conventional consumption-smoothing models would predict. The second part tests for the existence of asymmetric effects of terms of trade disturbances while controlling for various standard determinants of private savings. The results, based on panel data for non-oil commodity exporters of sub-Saharan Africa for the period 1980-1996, indicate that periods of increases in the permanent component of the terms of trade tend indeed be associated with higher rates of private savings.     

Inflation,R&D and growth in an open economy

This study explores the long-run effects of inflation in a two-country Schumpeterian growth model with cash-in-advance constraints on consumption and R&D investment. We find that increasing domestic inflation reduces domestic R&D investment and the growth rate of domestic technology. Given that economic growth in a country depends on both domestic and foreign technologies, increasing foreign inflation also affects the domestic economy. When each government conducts its monetary policy unilaterally to maximize the welfare of domestic households, the Nash-equilibrium inflation rates are generally higher than the optimal inflation rates chosen by cooperative governments who maximize the welfare of both domestic and foreign households. Under the CIA constraint on R&D (consumption), a larger market power of firms amplifies (mitigates) this inflationary bias. We use cross-country panel data to estimate the effects of inflation on R&D and also calibrate the two-country model to data in the Euro Area and the US to quantify the welfare effects of decreasing the inflation rates from the Nash equilibrium to the optimal level.     

Immiserizing growth for a tariff-distorted,small economy: Further analysis

The paper derives an exact criterion for deciding if capital accumulation in a small, open economy where the only distortion is a tariff on imports will result in a loss of welfare–a possibility shown by Johnson. The relationship with a previous criterion derived by Bertrand and Flatters is discussed.     

A dynamic quantity adjustment process in a small open economy,and welfare effects of tariff changes

Considered an n-good small open economy where the technology is strictly convex and ad valorem tariffs are imposed. In this world it is known that the tariff-utility relationship may be perverse. The fact is known as the Vanek–Bhagwati Paradox. The source of the perversity is found in aggregate income effects. The present paper shows that D-stability of our dynamic system implies non-perverse aggregate income effects, and hence the non-perverse tariff-utility relationship.     

Into the Mussa puzzle: monetary policy regimes and the real exchange rate in a small open economy

Industrial countries moving from fixed to floating exchange rate regimes experience dramatic rises in the variability of the real exchange rate. This evidence, forcefully documented by Mussa [Nominal exchange regimes and the behavior of real exchange rates: evidence and implications. Carnegie-Rochester Conference Series on Public Policy 25 (1986) 117], is a puzzle because it is hard to reconcile with the assumption of flexible prices. This paper lays out a dynamic general equilibrium model of a small open economy that combines nominal price rigidity with a systematic behavior of monetary policy able to approximate a continuum of exchange rate regimes. A version of the model with complete exchange rate pass-through is broadly consistent with Mussa’s findings. Most importantly, this holds independently of the underlying source of fluctuations in the economy, stressing the role of the nominal exchange rate regime per se in affecting the variability of the real exchange rate. However, only a model featuring incomplete exchange rate pass-through can account for a broader range of exchange rate statistics. Finally there exist ranges of values for either the degree of openness or the elasticity of substitution between domestic and foreign goods for which the baseline model is also consistent with the empirical insensitivity of output volatility to the type of exchange rate regime, as documented by Baxter and Stockman [Journal of Monetary Economics 23 (1989) 377].