To provide sharp answers to basic questions in international trade, a standard approach is to focus on a small open economy (SOE). Whereas the classic tradition is to define a SOE as an economy that ...takes world prices as given, in the new trade literature it is defined instead as one that takes foreign-good prices and export demand schedules as given. We develop a gravity model that nests all its standard microfoundations and show how to take the limit so that an economy that becomes infinitesimally small behaves like a SOE. We then derive comparative statics and optimal policy for the SOE. Ignoring standard tax indeterminacies, optimal policy is characterized by export taxes and import tariffs equal to the (inverse) foreign demand and supply elasticities, respectively, and employment subsidies determined by the scale elasticity (under perfect competition) or markups (under monopolistic competition).
We study the macroeconomic consequences of a major trade disruption using the example of the Finnish–Soviet trade collapse in 1991. This is a rare case of a well–identified large trade shock in a ...developed economy. We find that the shock significantly affected Finnish output. Even so, the trade collapse was insufficient to generate an all–out crisis, and accounts for only a part of the Finnish Great Depression (1990–1993). We show that shocks originating domestically played a major role throughout the depression.
We study how financial frictions affect the importance of trend productivity shocks for macroeconomic fluctuations. Using long-run data from 17 small open economies (SOEs), we compare two variants of ...a workhorse SOE real business cycle model featuring a debt-elastic interest rate (DEIR), a measure of financial frictions. The first variant estimates the DEIR parameter, while the second fixes it to 0.001, effectively abstracting from financial frictions. On average, ignoring financial frictions doubles the contribution of trend shocks to output fluctuations. This suggests that a proper assessment of the quantitative effects of trend shocks requires reasonable DEIR values.
We examine how inequality and openness interact in shaping the long-run growth prospects of developing countries. To this end, we develop a Schumpeterian growth model with heterogeneous households ...and non-homothetic preferences for quality. We show that inequality affects growth very differently in an open economy as opposed to a closed economy: If the economy is close to the technological frontier, the positive demand effect of inequality on growth found in closed-economy models may be amplified by international competition. In countries with a larger distance to the technology frontier, however, rich households satisfy their demand for high quality via importing, and the effect of inequality on growth is smaller than in a closed economy and may even be negative. In such case trade gives rise to the endogenous emergence of a ‘dual economy’ where some domestic sectors are highly innovative while others are not.
•The growth effects of inequality depend critically on a country's openness to trade.•Higher inequality increases incomes of the rich and their demand for innovation.•In closed economies, inequality is thus beneficial for innovation and growth.•In open developing countries, inequality increases imports and harms growth.•Foreign competition results in the endogenous emergence of a dual economy.
We study for a benchmark small open emerging economy an optimal robust monetary policy à la Hansen and Sargent (2003) considering additive model uncertainty. The robust control approach supposes that ...economic agents are not able to assign probabilities to a set of all plausible models and rather focuses on the worst possible misspecification from a benchmark model. Our findings are threefold. First, conducting a global robust optimal monetary policy can be limited since the departure from the benchmark model leads to multiple equilibria. Second, when model uncertainty arises only from the IS curve or the UIP condition, the space of unique solutions is expanded. In fact, when the central bank has a preference for robustness on the IS curve only, it should be more aggressive to demand and real exchange rate shocks but more conservative to cost-push shocks. On the other hand, when it has a preference for robustness only for the UIP, the central bank should be more aggressive to demand and cost-push shocks. Third, a sensitivity analysis suggests that conducting a global robust optimal monetary policy with the same misspecification in all equations is limited due to the persistence of inflation, the low exchange-rate pass-through and the need to anchor inflation expectations. Finally, we propose a Bayesian estimation for the Sidaoui and Ramos-Francia’s model over the period 2001–2019.
This paper develops a small open economy model that incorporates a services sector and explores the consumption and welfare effects of deregulation of that sector. Our model is an extension of the ...new open economy macroeconomics model, which allows us to analyze the macroeconomic effects of deregulation more clearly. The study shows that deregulation in the services sector increases long-run service production and consumption and lowers the consumer price index in the long run, yet has no impact on short-run service production, consumption, and prices. Regarding welfare, deregulation in the home country always benefits that country.
Emerging economies, particularly those dependent on commodity exports, are prone to highly disruptive economic cycles. This paper proposes a small open economy model for a net commodity exporter to ...quantitatively study the triggers of these cycles. The economy consists of two sectors, one of which produces commodities with prices subject to exogenous international fluctuations. These fluctuations affect both the competitiveness of the economy and its borrowing terms, as higher commodity prices are associated with lower spreads between the country's borrowing rate and world interest rates. Both effects jointly result in strongly positive effects of commodity price increases on GDP, consumption, and investment, and a negative effect on the total trade balance. Furthermore, they generate excess volatility of consumption over output and a large volatility of investment. Besides explicitly incorporating a double role of commodity prices, the model structure nests the various candidate sources of shocks proposed in previous work on emerging economy business cycles. Estimating the model on Argentine data, we find that the contribution of commodity price shocks to fluctuations in post-1950 output growth is in the order of 38%. In addition, commodity prices account for around 42% and 61% of the variation in consumption and investment growth, respectively. We find transitory productivity shocks to be an important driver of output fluctuations, exceeding the contribution of shocks to the trend, which, though smaller, is not negligible.
We derive a small open economy (SOE) as the limit of an economy as the number or size of its trading partners goes to infinity and trade costs also go to infinity. We obtain this limit in the ...Armington, Eaton–Kortum, Krugman, and Melitz models. In all cases, the trade of the SOE with the foreign countries approaches a finite limit, and the domestic expenditure share for the SOE approaches a limit that is not zero or unity. The foreign countries can be either infinitely many SOEs, or alternatively, one or many large countries with domestic expenditure shares that approach unity. We illustrate the usefulness of this framework by obtaining a formula for the optimal tariff in the SOE – depending on the elasticity of domestic wages with respect to the tariff – that is consistent with all models.
This paper demonstrates that an estimated, structural, small open-economy model of the Canadian economy cannot account for the substantial influence of foreign-sourced disturbances identified in ...numerous reduced-form studies. The benchmark model assumes uncorrelated shocks across countries and implies that U.S. shocks account for less than 3% of the variability observed in several Canadian series, at all forecast horizons. Accordingly, model-implied cross-correlation functions between Canada and U.S. are essentially zero. Both findings are at odds with the data. A specification that assumes correlated cross-country shocks partially resolves this discrepancy, but still falls well short of matching reduced-form evidence. One central difficulty resides in the model's inability to account for comovement without generating counter factual implications for the real exchange rate, the terms of trade and Canadian inflation.
This paper develops a small open economy model where a strong liquidity preference causes persistent stagnation and shows that a decline in the world real interest rate worsens the stagnation if the ...rate is already low enough.
•This paper analyzes persistent stagnation in a small open economy model.•The cause of persistent stagnation is a strong liquidity preference.•A fall in the world real interest rate worsens stagnation if the rate is already low.
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