Welfare and macroeconomic policy in small open economies

• Main Author: De Paoli, Bianca Shelton C.
• Published: London School of Economics and Political Science (University of London) 2006
• Subjects: 330.122
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.432895

This thesis focuses on the analysis of welfare and macroeconomic policy in small open economies. The international dimension of monetary and fiscal policy is examined in a micro-founded New-Keynesian framework. The small open economy is characterized as a limiting case of a two-country dynamic general equilibrium model featuring imperfect competition and nominal rigidities. Under this specification, Chapter 1 formulates a utility-based loss function for a small open economy completely integrated with the rest of the world. The study investigates the role of the exchange rate in monetary policy and derives the optimal monetary policy rule. In this Chapter, the dynamics of the trade balance are shown to be crucial in determining the appropriate exchange rate regime. Chapter 2 analyses optimal monetary policy under alternative asset market structures; more specifically, it compares and contrasts the cases of incomplete asset markets, financial autarky and complete asset markets. Furthermore, the performance of standard monetary policy rules is evaluated under these different scenarios. The results show that the degree of substitutability between domestic and foreign goods and the level of risk sharing are important factors in determining the performance of policy rules. Finally, Chapter 3 incorporates fiscal policy in the general framework. This Chapter introduces distortionary taxation into the model and characterizes the optimal fiscal policy. In addition, a general monetary and fiscal policy problem is formulated in the presence of nominal rigidities. The Chapter demonstrates that the stabilization problem in an open economy is more complex than in a closed economy, even under flexible prices. Apart from the incentive to avoid the distortions implied by taxation, in a small open economy there is also an incentive to strategically affect the real exchange rate. That is, proportional taxation creates a distortion in the economy, but also introduces a policy instrument that can influence the terms of trade and the overall level of production and consumption in a welfare-improving manner.