Small Open Economy Research Articles

Economic uncertainty and corporate cash holdings: Evidence from Taiwan

We utilize data from publicly listed firms and unlisted entities in Taiwan spanning the period from 1990 to 2020 to investigate the impact of global, Asia-Pacific, China, or Taiwan’s economic uncertainty on firm cash reserves within a small open economy. Our empirical findings indicate that, as economic uncertainty increases, Taiwanese firms demonstrate a tendency to increase their cash holdings, particularly those reliant on exports. Smaller and unlisted export-oriented firms encounter greater challenges in fund management, thereby leading to an augmentation in their cash reserves. Conversely, enterprises primarily focused on domestic sales exhibit a diminished response to uncertainty, with the exception of smaller listed companies that marginally raise their cash holdings. These results illuminate the influence of financing constraints, export reliance, and various uncertainties on decisions pertaining to cash holdings. Furthermore, the study underscores the dependence of Taiwanese firms on trade and emphasizes the impact of external economic uncertainty on their decision-making process.

Central bank losses, monetary policy rules, and limited information

Since the Global Financial Crisis, a lively debate has emerged regarding the monetary policy rule the central bank of a small open economy (SOE) follows and should follow. By identifying the monetary policy rule that best fits historical data and minimizes central bank loss functions, this study contributes to this debate. We estimate a medium-scale micro-founded SOE model under various monetary policy rules using Israeli data from 1994 to 2019. Our results show that simple inflation targeting (IT) rules are more appropriate than hybrid rules targeting the exchange rate. Given central bank goals, shock uncertainty, and limited information, nominal income targeting rules may have been more desirable over the last three decades than IT rules.

Correction to: Optimal policies in a small open economy with an environmental externality and shallow foreign exchange markets

Correction to: Optimal policies in a small open economy with an environmental externality and shallow foreign exchange markets

Quantitative Easing, Bond Risk Premia and the Exchange Rate in a Small Open Economy

We assess the impact of large-scale asset purchases, commonly known as quantitative easing (QE), conducted by Sveriges Riksbank and the European Central Bank (ECB) on bond risk premia in the Swedish government bond market. Using a novel arbitrage-free dynamic term structure model of nominal and real bond prices that accounts for bond-specific safety premia, we find that Sveriges Riksbank’s bond purchases raised inflation and short-rate expectations, lowered nominal and real term premia and inflation risk premia, and increased nominal bond safety premia, suggestive of signaling, portfolio rebalance, and safe asset scarcity effects. Furthermore, we document spillover effects of ECB’s QE programs on Swedish bond markets that are similar to the Swedish QE effects only after controlling for exchange rate fluctuations, highlighting the importance of exchange rate dynamics in the transmission of QE spillover effects.

Uncertainty and Information Acquisition: Evidence from Firms and Households

We leverage the small open economy Switzerland as a testing ground for basic premises of macroeconomic models of endogenous information acquisition, using tailored surveys of firms and households. Firms and households perceiving a greater exposure to exchange rate fluctuations acquire more information about the exchange rate. Moreover, higher perceived costs of acquiring or processing information are associated with lower levels of information acquisition. Finally, an exogenous increase in the perceived uncertainty of the exchange rate increases firms’ demand for a report about exchange rate developments, but not households’. Our findings inform the modeling of information frictions in macroeconomics. (JEL D12, D22, D81, D83, D84, E71, F31)

Financial frictions in a macroeconometric model: A counterfactual analysis for the case of Slovenia

The paper investigates the importance of modelling the effects of financial frictions in a macroeconometric framework for the small open economy of Slovenia. We enhance the model with additional behavioural equations pertaining to business and residential investment, the respective lending rates, and the gross operating surplus of non-financial companies. The estimation period spans from 1999Q1 to 2019Q4, meaning a period of significant financial distress was included in the analysis. Counterfactual analysis was conducted by comparing simulation results from a macroeconometric model with the explicit modelling of financial frictions to a model with limited transmission effects. The results indicate that financial frictions significantly hinder macroeconomic development under adverse macroeconomic scenarios. Policymakers’ measures should focus on maintaining financial sector stability and enabling external financing access for non-financial companies and households during adverse economic situations.

Specialization, market access and real income

This paper estimates the impact of external demand shocks on real income. We utilize a first order approximation to a wide class of small open economy models that feature sector-level gravity in trade flows, which allows us to measure foreign shocks and characterize their welfare impact in terms of reduced-form elasticities. We use machine learning techniques to group 4-digit manufacturing sectors into a smaller number of clusters, and show that the cluster-level elasticities of income with respect to foreign shocks can be estimated using high-dimensional statistical techniques. Foreign demand shocks in complex intermediate and capital goods have large positive impacts on real income, whereas impacts in other sectors are negligible. We show that the estimates imply that countries that specialize in these sectors enjoy greater gains from increased openness, and that (small) export subsidies to these sectors are welfare-improving. Finally, a calibrated multi-sector production and trade model with input–output linkages and external economies of scale can match the empirical estimates.

Inflation returns. Revisiting the role of external and domestic shocks with Bayesian structural VAR

Following recent exceptional events in the world economy inflation increased remarkably across most countries, reinvigorating the prevalent discussion on the sources of consumer price dynamics. We analyse this issue for the small open economy of Poland by means of the Bayesian structural VAR. The model describes the evolution of eight key macroeconomic variables and is identified with a set of zero and sign restrictions. This framework, applicable also to other small open economies, provides sound economic interpretation of three domestic and five external shocks, of which two are country-specific and the remaining three are purely global. In a robust manner we show that country-specific energy price shocks and global supply shocks mostly determine the recent inflation surge in Poland. We illustrate that inflation response to these two shocks has become markedly more persistent after the outbreak of the Covid-19 pandemic. We also demonstrate that the choice of an inadequate energy prices proxy may result in underestimating the contribution of the energy price shock to inflation, whereas accounting for recent geopolitical threats and other exogenous events does not alter our baseline findings.

Star help and knowledge transfer: an event study analysis of star interactions observed from acknowledgement texts

AbstractThis paper contributes to the growing literature on the impact of connections to star scientists on the productivity of academic scientists. The existing literature generally focuses on larger economies and specific scientific fields in evaluating star-connection effects. It has rarely examined the particular channels through which stars have their effects. Using natural language processing (NLP) techniques to explore the acknowledgement texts of a broad corpus of published papers from three small open economies, we examine the effects of star help revealed by the acknowledgement texts published in articles. Using an event-study framework with matched data, we find evidence of an economically and statistically significant effect on scientist productivity in the year of acknowledgement of star help. However, there is only evidence of an enduring productivity effect if scientists maintain their acknowledgement of ties to the star over time. A similar pattern is evident across different types of acknowledgements, except for acknowledgements of star help with access to materials, which shows an enduring effect even after a single acknowledgement. The largest estimated star-help effects are found for authors in lower quartiles of the field-specific productivity distribution measured in the year before the help is acknowledged. The results are robust to using a raw-publications-based measure of scientist productivity in place of our preferred citation-weighted publications measure of productivity, suggesting that the observed productivity effect is unlikely to be due to a pure signalling effect. We discuss the implications of these findings for the design of star recruitment and integration policies.

Optimal policies in a small open economy with an environmental externality and shallow foreign exchange markets

Optimal policies in a small open economy with an environmental externality and shallow foreign exchange markets

Inequality and Asset Prices during Sudden Stops

This paper studies the cross-sectional dimension of Fisher’s debt-deflation mechanism that triggers Sudden Stop crises. Analyzing microdata from Mexico, we show that this dimension has macroeconomic implications that operate via opposing effects. We propose a small open economy, asset-pricing model with heterogeneous-agents and aggregate risk to measure the effects of inequality during crises. In contrast to a representative-agent model, heterogeneity generates persistent current account reversals with smaller drops in asset prices and larger drops in consumption driven by the leveraged households. Moreover, in a lower inequality calibration, we find that crises are less severe, as observed in the data.

The relationship between bureaucratic corruption and financial crisis in an open economy

This paper contributes to that debate via a novel examination of the relationships among bureaucratic corruption, growth, and financial crisis in an open economy, using a two-period small open economy model. The outcome shows that the uncertainties created by corruption in such an economy constitute a double-edged sword. That is, when the economy is prosperous, corruption can ‘grease’ the economic system and infuse some motive power into economic activities, and thus help to boost growth. Contrarily, if the economy is experiencing a depreciation, corruption could turn to be an obstacle to growth and even contribute meaningfully to financial crises.

Impacts of Monetary Policy Shocks on Inflation and Output in New Zealand*

We identify monetary policy shocks in New Zealand as 1‐day changes in the whole yield curve around monetary policy announcements. The impacts of these shocks on inflation and output are estimated using functional local projections. We find that the effects of monetary policy shocks are standard in the short run but might be different in the long run. Monetary policy shocks in a small open economy have similar effects as in a large economy, except that unconventional monetary policy announcements have limited impact on long‐term interest rates. Accounting for forward guidance, used in New Zealand since 1997, is important.

The transmission of U.S. monetary policy to small open economies

This paper studies the transmission of a U.S. monetary policy tightening to a set of small open economies. It uses as policy instruments Wu and Xia (2016) shadow rate, the Fed funds rate (conventional monetary policy, CMP) and changes in the Fed balance sheet (unconventional monetary policy, UMP). The main findings include: (1) the shock always reduces foreign economic activity and contributes to the emergence of a “global” financial cycle. (2) The financial channel has become more important since 2008. 3) There is evidence of an oil transmission channel. (4) Cross-country differences do not depend on their international trade volume, exchange rate flexibility or financial openness. U.S. policymakers may need to consider the feedback effects of changes in their policy stance on world demand and inflation. Small open economies should assess the type of U.S. monetary policy shock to evaluate the channels through which their economies may be affected.

Labour Market Effects of Trade in a Small Open Economy

Austria is a small open economy that in the last decades underwent two different waves of increasing trade integration: one with Eastern Europe and one with China. Drawing on trade theory, this paper studies the effects of increases in trade with China and Eastern Europe on labour market dynamics in Austrian NUTS-4 regions for two ten-year periods between 1995 and 2015. Given the limited data available, the current analysis could not identify significant effects on aggregate labour dynamics neither for rising imports from Eastern Europe or China, nor for rising exports to Eastern Europe. However, there is weak evidence that exports to China have facilitated employment growth, especially in high quality segments. Overall, these results add a cautious perspective to the discussion of import competition.

The limits to redistribution in small open economies: the case of Argentina

The specialized literature on the political economy of income redistribution in Argentina usually focuses on economic limits. It discusses the incompatibility between redistributive policies and the external balance or their effect on the long-term growth rate. However, less attention has been paid to the political resistance exerted by the winners of international trade to sharing their gains and to the role of financial integration. In this paper, we develop a model, framed in the modern revival of Classical theory, of a small open economy with differential rent to account for these factors. First, we include interests as an income category to assess the impact of financial integration. Second, we introduce the concept of ‘political stalemate’ – the resistance of productive classes to economic policies that go against their economic interest. We show how financial integration and the political resistance of landowners are behind the failure of income redistributive policies in favor of workers. In this context, we analyze the necessary economic and political conditions for such policies to succeed.

Fiscal Fatigue, Public Debt Structure and Sustainability: A DSGE Model for West African Economic and Monetary Union

The present paper simulates several financing schemes for scaling-up public investment while stabilizing debt in WAEMU countries experiencing fiscal fatigue. We construct a DSGE model of a small open economy that incorporates the behaviour of four types of agents: firms, households, government, and the Central Bank. The analysis assumes that when the government faces fiscal fatigue, it can turn to debt to finance the scaling-up of public investment. To ensure long-term debt sustainability, fiscal adjustments are consistently implemented through transfers and/or taxes, subject to respective caps and floors. Simulations indicate that, in the presence of natural resource revenues, scaling up public investment is feasible using concessional borrowing only or by incorporating additional external commercial or domestic borrowing while maintaining debt sustainability. Otherwise, external commercial debt appears to carry more risk.

Urban unemployment, environmental preservation and trade policies in a small open economy with open access renewable resources

This study presents a two-sector dynamic analytical model that examines the impact of trade policies on urban poverty reduction and resource conservation, given that institutionally fixed high urban wages are assumed in the context of the Harris-Todaro model. Rural resource-good and urban manufacturing activities generate simultaneous environmental pressures that can detrimentally impact environmental preservation in a small, open economy. Moreover, this study assumes that the polluting manufacturing sector is the primary cause of environmental degradation and represents a relatively more industrialized developing country. The study finds that raising the import tax on rural resource goods can reduce urban unemployment but worsen environmental quality under dynamic resource conditions. Given institutional distortions, the most efficient policy is to implement a rural income subsidy combined with an urban wage subsidy at a lower rate; alternatively, if the income inequality between regions is sufficiently high, an income tax on urban manufactured goods could be considered. Finally, when considering the endogenous resolution of institutional distortions, an increase in the import tax on rural resource goods can resolve rural institutional distortions, shifting from poorly defined resource management to a perfect private management system. In contrast, implementing an export tariff policy on urban manufactured goods reduces the incentive for rural institutional reform while addressing urban institutional failure.

Central bank communication and expectations: Evidence for inflation‐targeting economies

AbstractWe seek to investigate the effects of communication by central banks on professional and consumer inflation expectations. Accordingly, we investigate 12 small open economies implementing inflation targeting. The communication tone of the central banks is determined based on their post‐decision releases. We use computational linguistics to quantify this factor. With regard to two subsamples that are identified based on the central bank's experience in inflation targeting, we estimate panel models while controlling for other prospective drivers of expectations. The communication tone of a central bank significantly affects the expectations of professional forecasters from economies with more experience in inflation targeting.

Demand‐led industrialisation policy in a dual‐sector small open economy

AbstractThis article models the process of structural transformation and catching‐up in a demand‐led Southern economy constrained by its balance of payments. Starting from the Sraffian Supermultiplier Model, we model a dual‐sector small open economy with a traditional and a modern sector that interacts with a technologically advanced Northern economy. We propose two (alternative) autonomous elements that define the growth rate of this demand‐led economy: government spending and exports. Drawing from the Structuralist literature, productivity in the technologically laggard Southern economy grows by absorbing technology from the Northern economy, by both embodied and disembodied spillovers, and potentially closing the technology gap. The gap affects the income elasticity of exports, bringing a supply‐side mediation to the growth rates in line with the Balance of Payments Constrained Model. We observe that a demand‐led government policy plays a central role in structural change, pushing the modern sector to a larger share of employment than what results under export‐led growth. Such a demand policy is the only way in which partial catching up (in productivity and GDP per capita) can result, and this is facilitated by a global market place in which the balance of payments constraint is relatively soft.