Limits to Fiscal and Monetary Policy in Small Open Economies

In this paper we investigate the impact of the balance-of-payments constraint on output, income distribution and policy space in a small economy open to both commercial and financial flows. We do so by extending a Sraffian supermultiplier growth model to consider current and capital accounts and endogenous money. Expansionary fiscal policies increase output and its long run growth rate but have a negative impact on the balance-of-payments. Based on these results, we derive the value of government spending that maximises output while maintaining external equilibrium.Monetary policy also influences the balance-of-payments by attracting foreign financial flows through higher interest rates. This relationship is non-monotonic, since these flows can finance the external deficit resulting from a high output level but can also lead to a greater interest burden. This trade off allows us to find the level of the interest rate that maximises external space. It also implies that, with limits, raising interest rates might allow for higher real wages.Lastly, we examine the effects of the currency denomination of debt. We find that, in case of a depreciation, debt in domestic currency allows for a less contractionary adjustment than foreign currency-denominated debt but does not lead to higher economic growth.