Twin Deficits versus Unpleasant Fiscal Arithmetic in a Small Open Economy
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This paper studies fiscal deficits, consumption-saving behavior, current account imbalances, and exchange rates in a small open economy populated by households with finite lives. Suppose the government undertakes a bond-financed tax cut today. The authors find that if tax finance is anticipated primarily to be used in the future to close the deficit then 'twin deficits' will be observed today, but if money finance is anticipated primarily to be used in the future then current fiscal deficits will induce a decline in current consumption, thus creating trade surpluses, a result they term 'unpleasant fiscal arithmetic.' Copyright 1995 by Ohio State University Press.Keywords:
Consumption
Small open economy
Fiscal deficit
Open economy
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Small open economy
Open economy
Investment
Intermediate good
Terms of trade
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We study the term premium on nominal and real government bonds in a small open economy within a micro-founded DSGE model with Epstein- Zin preferences. We solve the model using a third-order approximation to allow for time-varying risk premia. We thus extend previous work on closed economies to the case of a small open economy. We find that tech- nological spillovers from the global economy to the small open economy are essential for the ability of the model to produce concurrently a sub- stantial positive nominal term premium, realistic variability of the main macroeconomic variables, and high correlations between the global and domestic economies as evident in the data. We use the model to study the effect of the openness of the economy on bond risk premia. We identify two opposing effects of the openness of the economy on the nominal term premium. The better ability of the open economy to accommodate domes- tic shocks works to decrease the term premium in the open economy. By contrast, in the presence of technological spillovers from the global econ- omy to the small open economy, the foreign technological shock generates a higher term premium in the open economy compared to a closed one. Quantitatively, in our model these effects roughly offset each other so that the term premium in the open economy is similar to the premium in an otherwise similar economy that is closed to trade in goods and financial assets.
Small open economy
Open economy
Openness to experience
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Two final goods, one primary factor and one resource model was developed to examine the effects of free trade on a small open economy when open-access resources are used as an intermediate to produce the final goods. We suppose only the final goods to be tradable and restrict our attention to the steady state of this economy. Then we investigated the production patterns and economic welfare. The mechanism behind this model follows the Rybczynski theorem in the standard Heckscher-Ohlin model, but responses to the resource harvest and outputs to a change in the relative price are ambiguous. The production patterns and welfare gains depend on the equilibrium resource stock before trade. Under some circumstances, a small open country may suffer from trade, while free trade may also mitigate the overuse of the resource stock.JEL Classification: F11, F18, Q22, Q27, Q28
Small open economy
Intermediate good
Open economy
Stock (firearms)
Terms of trade
Economic welfare
Gains from trade
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Countries specialize in producing goods that they have comparative advantages in producing. This results in a country exporting some goods while it imports other. Hence, there is a reason to expect that changes in the prices of these goods have consid- erable economic e¤ect and that demand management can be used to improve welfare following such changes. This paper analyses this using a New Open Economy Macro (NOEM) model of a small open economy. Among others, the results indicate that, in a small open economy, a terms of trade appreciation results in increased consumption, labor use and output on impact while consumption increases but labor use and output decrease in future time periods. The results also indicate that the vulnerability of an economy towards such shocks is negatively related to its size. Finally, the results indicate that there exists a welfare improving demand management policy following a terms of trade shock.
Small open economy
Open economy
Consumption
Vulnerability
Macro
Terms of trade
Demand shock
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This paper tests the validity of the twin deficit hypothesis, the causal relationship between fiscal deficit (FD) and current account balance (CAB), in India for the period 1994-2016 by estimating a structural model that includes the interest rate and exchange rate as an interlinking variable. The SVAR estimates show a negative effect implying that a positive shock given to FD worsens the CAB. The current account deficit, while not directly determined by fiscal deficit, is significantly influenced by RIR and REER. The IRF indicates that a positive shock to FD leads to an increase in the domestic interest rate which appreciates the real exchange rate of the domestic currency making the exports costlier and imports cheaper and thereby widening the current account deficit. The SVAR, IRF and Granger causality analyses show that fiscal deficit affects the current account balance in India through the interlinking variables RIR and REER for the time period 1994 (quarter-I) to 2016 (quarter-IV). This result validates the relevance of the twin deficit hypothesis in the Indian economy and is consistent with the Keynesian proposition in the Indian economy during the study period.
Fiscal deficit
Balance of trade
Structural break
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The purpose of this paper is to test the twin deficit hypothesis and empirical relationship between current account balance and budget deficit while including other important macroeconomic variables such as growth, interest rates, money supply (M3) in Kenya from 1963-2012. The study was based on co integration analysis and error correction model (ECM). The results reveal a long-run association between the trade deficit and the fiscal deficit. The findings indicate that the Keynesian view fits well for Kenya since the causality runs from budget deficit to current account deficit. We detected unidirectional causation between the twin deficits, running from budget deficit to current account directly and indirectly through budget deficits which raise real interest rates, crowd out domestic investment, and cause the currency to appreciate in relation to the other currencies and further deteriorates the current account deficit.
Deficit spending
Balance of trade
Fiscal deficit
Money supply
Causality
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In this paper, I re-examined standard preferences in a small open economy (SOE) model with indivisible labor calibrated to Canada. It is well known that dynamic small open economy models rely on Greenwood, Hercowitz and Huffman (1988) preferences to match the countercyclical trade balance observed in open economies, as well as other second moments. In contrast, standard preferences a la King, Plosser and Rebelo (1988) are abandoned in this literature and are commonly labeled as ineffective, due to their inability to yield a countercyclical trade balance. Contrary to prior claims, this paper shows that a SOE model with standard preferences and indivisible labor obtains a countercyclical trade balance and well matches main empirical regularities that emerge in open economies.
Small open economy
Open economy
Balance of trade
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In a two good, two factor small open economy with neoclassical production functions, we investigate conditions for Giffenness of imports with respect to the price of the imported good. Of interest is the shape of the consumption-trade frontier (the locus of points chosen as world prices vary) under Giffenness. It is concave to the origin. We note the implications of this for the small open economy facing fluctuating terms of trade.
Small open economy
Open economy
Frontier
Consumption
Terms of trade
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Small open economy
Open economy
Infinity
Product Differentiation
Elasticity
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ABSTRACT Studying exchange rate pass‐through in Turkey for the period of 2006m1‐2015m6, we first show that the commonly used recursive VAR model generates unrealistic dynamics like effects of domestic variables on external variables in small open economies and biased estimates. Bias comes from unrealistic decline in energy prices in response to depreciation of currency. However, a more realistic structural VAR model suitable for small open economies generates more sensible dynamics and suggests a higher pass‐through than the recursive VAR model. Overall, our analysis demonstrates the importance of using a more realistic model setup and checking the relationships across variables when estimating ERPT in small open economies.
Small open economy
Depreciation (economics)
Open economy
Exchange-rate pass-through
Local currency
Vector autoregression
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