Imported inputs in an optimising model of a small open economy

Abstract

This paper addresses two issues. First, a model of optimising behaviour in a small open economy is presented and analysed. A solution is presented to the problem of inconsistency between the domestic discount rate and the world interest rate using Rawl's criterion for economic justice. The resulting model of a small open economy has sensible properties and resembles non-optimising models used in open economy macroeconomics. Second, the analysis is extended to allow for a single imported factor of production and the impacts of a rise in its world price are examined. The long run effects are: a loss of economic welfare; a reduction in the domestic capital stock on plausible assumptions about Hicks-Allen complementarity; a possible appreciation of the exchange rate in the long run, although a short run depreciation is also possible; and an ambiguous effect on the stock of foreign equities owned by the small economy.