The Limits to Demand Management in Small and Open Economies

Macroeconomic policy in small and open economies has come to be identified with demand management primarily in the form of fiscal policy. Manipulations of such instruments are asserted to be an effective means to control the level of activity in economics with a fixed exchange rate regime, as brought out most clearly in the Mundell-Flemming model (see e.g. Marston (1985)). The associated distinction between expenditure-reducing and expenditure-switching policies points out the two types of demand management policies needed to attain both internal and external objectives, c.f. Corden (1978). It has been observed that fiscal policy instruments induce both reducing and switching effects since they in general do not affect tradeable and non-tradeable sectors symmetrically (Söderström and Viotti (1979) and Söderström (1985)). The double balance problem (being a primary concern of small and open economies) can thus be solved by a demand-management strategy according to which private demand is reduced and public demand is expanded, since this reduces the excess demand for tradeables while expanding activity in the non-tradeables sector. In this way, it is conjectured that the trade deficit can be transformed into more employment.