Limits on fiscal and monetary policy in small open economies

Working papers| 2023 | N 109

Abstract

This article studies how the balance of payments can limit growth and income distribution in a small economy open to both trade and international financial flows, as well as reduce the space for the implementation of autonomous fiscal and monetary policies. The analysis is carried out by extending an economic growth model based on the Sraffian supermultiplier to consider trade and financial flows in an endogenous money framework. An expansionary fiscal policy favors product growth, but also has a negative effect on the balance of payments by increasing imports. This allows the value of public spending to be derived that maximizes the level of output without giving rise to an external imbalance. Monetary policy also has a significant role in the dynamics of the external sector, given that higher domestic interest rates can attract financial flows and therefore foreign exchange. However, this relationship is not monotonous, since financial flows can finance the trade deficit, but also generate interest payments that demand foreign currency. This trade off makes it possible to obtain an interest rate that maximizes the external space, which means that, and under certain conditions, increases in the interest rate can make improvements in the real salary viable. Finally, a debt policy in domestic currency is compared with another in foreign currency. We find that, in the face of an external crisis, the first allows the stock of foreign exchange to be recomposed more quickly and in a less contractive manner than the second, but is not necessarily capable of accommodating higher rates of economic growth.

JEL classification: E11; E25; E52; E62; E43