Limits to Fiscal and Monetary Policy in Small Open Economies

Ariel Dvoskin () and Matías Torchinsky Landau ()
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Ariel Dvoskin: Central Bank of Argentina
Matías Torchinsky Landau: CONICET-IDAES

No 2023109, BCRA Working Paper Series from Central Bank of Argentina, Economic Research Department

Abstract: This article studies how the balance of payments can constrain 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 based on an extension of an economic growth model grounded in the Sraffian supermultiplier, incorporating trade and financial flows within a framework of endogenous money. An expansionary fiscal policy promotes output growth, but also has a negative effect on the balance of payments by increasing imports. This makes it possible to derive the level of public spending that maximizes output without generating an external imbalance. Monetary policy also plays a significant role in the dynamics of the external sector, since higher domestic interest rates may attract financial flows and, therefore, foreign currency. However, this relationship is not monotonic: financial flows may finance the trade deficit, but they may also generate interest payments that require foreign currency. This trade-off makes it possible to obtain an interest rate that maximizes external space, implying that, under certain conditions, increases in the interest rate may enable improvements in the real wage. Finally, the article compares a policy of borrowing in domestic currency with one of borrowing in foreign currency. We find that, in the face of an external crisis, the former allows the stock of international reserves to be rebuilt more rapidly and in a less contractionary manner than the latter, but it is not necessarily capable of accommodating higher rates of economic growth.

Keywords: endogenous money; fiscal policy; income distribution; monetary policy; Sraffian supermultiplier; structuralism (search for similar items in EconPapers)
JEL-codes: E11 E25 E43 E52 E62 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2023-05
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