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The scope for an active demand management policy is considered for a small open economy. Business cycle fluctuations generated by supply and demand shocks are shown to imply welfare losses when agents are risk averse and the capital market incomplete. Public demand for non-tradeables has real effects and there is a welfare case for pursuing a demand management policy which stabilizes consumption. It is argued that this type of stabilization can be attained via automatic stabilizers based on nominal budgeting rules.

For more than a decade, reducing public budget deficits has been the overriding concern for fiscal policy analysis, and other issues have been devoted little attention. Yet in the last few years budget deficits have been reduced significantly in many industrialized economies, and while long-term issues related to pensions and demographic trends are still a matter of deep concern, more attention can again be given to the short-run effects of fiscal policy. However, much of the existing economic literature on fiscal policy is based on rather restrictive models that do not apply to the recent advances made in the macroeconomics literature.1 In particular a significant achievement of the recent development in the open macroeconomics literature is the formulation of explicit intertemporal models (see e.g. Obstfeld and Rogoff (1996) for an introduction and references). Very little is, however, known about the policy implications of these models. One exception is that it is often argued that the explicit intertemporal interpretation of the current account in terms of the underlying savings and investment decisions makes it misleading to have the current account or the trade balance as an intermediary target for economic policy making (see e.g. Corden, 1991; Razin, 1993). The aim of this paper is to consider the implications of business cycle fluctuations generated by supply or demand shocks in a small open economy. When agents are risk averse and capital markets incomplete, there is a welfare loss from the risks created by business cycle fluctuations. We show that demand management policy in the form of public demand for non-tradeables affects the real allocation. In particular there exists a demand management policy which can stabilize the tradeable sector and thereby consumption and thus lead to welfare improvements both when business cycle fluctuations are created by demand and supply shocks. The welfare case for this policy can be interpreted in the sense that it provides implicit or social insurance which mitigates the consequences of market failures precluding perfect consumption smoothing for households. Finally, we discuss whether simple forms of demand management policies can contribute to an appropriate stabilization, and we show that this can be accomplished via automatic stabilizers built into the public budget via nominal budget rules. Specifically the present paper is based on a two-sector model for a small open economy, with one sector producing a tradeable and the other a non-tradeable. There is perfect capital mobility but the available set of assets does not allow perfect diversification of the shocks inducing business cycle fluctuations. Since households are risk averse, it follows that there is a welfare loss due to fluctuations in consumption. In the present setting changes in public demand affect the equilibrium via two routes. First, via the implied change in taxes and its effect on disposable income and secondly via a change in the relative demand for tradeables and non-tradeables and thereby the terms of trade. An obvious objection to the topic of our paper is that stabilization should be the aim of monetary policy, and not of fiscal policy. We do not object to the view that monetary policy instruments should be used to stabilize the economy. However, for countries pursuing a fixed exchange rate policy (like all EMU countries) there is no autonomy in monetary policy. Moreover, even for countries with a floating exchange rate, recent experiences of the UK and New Zealand show that an active monetary policy may not prevent considerable imbalances between tradeables and non-tradeables sectors (see King, 2000; Brash, 2001). In contrast, as will be apparent from our analysis, fiscal policy may have a stabilizing effect on the sectoral distribution of the economy, as it may be targeted directly towards one of the sectors. This suggests that for stabilization purposes, fiscal policy should be seen as a complement to monetary policy rather than an alternative (cf. Røisland and Torvik, 1999). The model builds on two strong assumptions so as to facilitate the interpretation of the results. Ricardian Equivalence prevails implying that the case for an active stabilization policy does not follow from better access to capital markets for the public sector than for the private sector.2 In the same vein the model is real without any nominal rigidities to highlight that nominal adjustment failures are not necessary for demand management polices to have beneficial effects. The paper is organized as follows: The model is set up in Section 2, and Section 3 analyses the determinants of national wealth. The case of supply (productivity) shocks is considered in Section 4, and demand (preference) shocks are considered in Section 5. Section 6 considers the problems on how to implement this type of policy, and Section 7 offers a few concluding remarks.

In this paper we have investigated to what extent the fiscal policy can be used to stabilize an open economy under various types of shocks. This is an issue of considerable importance from a policy point of view, yet it has not received much attention in recent research. The main results within our model are as follows. Fiscal policy can be used to stabilize the economy both under supply (productivity) and demand (preferences) shocks. Given an incomplete capital market precluding diversification of income risks and risk averse agents, there is a welfare case for such a policy. An active demand management policy can thus mitigate the implications of capital market imperfections and in this way provide implicit or social insurance. In the specific cases considered here there exists a simple policy intervention which can stabilize consumption perfectly and therefore maximize welfare. The optimal policy involves stabilization of the real trade balance. This conclusion should not be pushed too far; as shown in models incorporating real capital, productivity shocks that affect the return to investments should be allowed to affect the trade balance (e.g., Obstfeld and Rogoff, 1995a). The appropriate interpretation of our paper is that, under some circumstances, the effect of productivity and demand shocks on the trade balance that arises via consumption behaviour should be neutralized under optimal policies. Under productivity shocks, the optimal fiscal policy is in sharp contrast to the Keynesian prescription, since public demand should be increased when output is high, owing to a positive productivity shock. However, under demand shocks the traditional Keynesian strategy prevails: public demand for non-traded goods should be increased in periods with low output in the non-tradeable sector. One reason for the difference in the appropriate policy response relative to the traditional Keynesian view-point lies in the fact that our policy is based on a welfare measure calling for stabilization of consumption rather than the traditional Keynesian objective of stabilization of aggregate activity. In practice, incomplete information makes it difficult to implement the optimal fiscal policy. Thus, we also investigated to what extent automatic budgeting reactions are in accordance with the optimal fiscal policy. We find that automatic budget rules where public real demand is counter cyclical have a stabilizing (and thus welfare improving) effect under demand shocks, whereas the effect is destabilizing under supply shocks. Nominal budget rules, specifying a certain level of nominal outlay on public demand for non-tradeables have, however, a stabilizing effect both under productivity and demand shocks. This suggests that existing automatic budget responses working primarily via real demands may be inappropriate and that there are gains to be reaped by changing to nominal budget rules. Does policy activism directed towards stabilizing consumption have any quantitative importance? Lucas (1987) argues that the gains are small, whereas Storesletten et al. (2000) argue that the gains can be substantial when risk diversification is important. The important point of the present analysis is that policy can affect consumption risk and thereby improve welfare when agents are risk averse and capital markets incomplete. The present model is, however, too stylized to yield a reliable reference point for evaluating the potential welfare gains from an active stabilization policy, in part because the model has been specified such that employment variability does not have welfare consequences. Since this type of risk is likely to be at least as important in practice as consumption risk, the case for an active stabilization policy would probably be much larger than suggested by the present analysis. Moreover, the results reported by Lewis (1999) suggest that the welfare consequences of insufficient risk diversification are non-trivial, and an important point of the present analysis is that an active stabilization policy may repair the consequences of market incompleteness. Our analysis only covers temporary shocks. As is apparent from the massive economic growth that many countries have experienced over the last century, there are also important permanent productivity shocks. In our model, permanent productivity shocks will move the economy towards a new steady state. However, in an important benchmark case, where net financial wealth is zero and public demand is adjusted in proportion to the productivity shock, the equilibrium relative price of non-tradeables will be the same in the new steady state solution as the old (neglecting any effects from the transition). Thus, nominal budget rules will be robust to permanent productivity shocks in this case. A more extensive exploration of the consequences of different kinds of shocks remains a topic for future research. In an increasing number of countries, the monetary policy is used actively with the aim of stabilizing the economy. However, in some countries, most notably the UK and New Zealand, there have been considerable imbalances between the tradeables and the non-tradeables sectors. In this perspective our finding that fiscal policy, even nominal budget rules, may have a stabilizing effect that can be targeted directly towards one of the sectors, seems to be of considerable interest.