Opportunities for fiscal devaluation in small open economies: the case of Ukraine

Abstract

This article examines the effects of fiscal devaluation on the trade balance of a country with a small open economy. It is assumed that typically such countries are price takers, which means low price elasticity of exports and imports. If this assumption is true, then it is impossible to make an impact on the trade balance through the price mechanism and, accordingly, fiscal devaluation will not have significant effects. To confirm or reject this hypothesis it is necessary to determine causal relationships between changes in the fiscal devaluation indicator and trade balance dynamics. Applying a series of causality tests to Ukrainian data, the authors argue that the dynamics of trade balance cause changes in VAT and social security contributions. The opposite causality was not detected. This is treated as evidence of fiscal devaluation's inefficiency in economies like Ukraine on one hand and of the price-taking characteristics of Ukraine on the other. The potential null effect of fiscal devaluation was confirmed with SVAR modeling.