Macroeconomic Policy in a Small Open Economy

Abstract

A two-sector model is used to discuss the effects of fiscal policy and exchange-rate variations in a small open economy. The emphasis is on a situation with unemployment and a restriction on the nominal wage rate. It is shown that indirect taxes have to be used in order for fiscal policy to make both sectors expand simultaneously. A shift from payroll taxes or the value-added tax to direct taxation will thus lead to increased production in both sectors. A devaluation is shown to be equivalent to a particular tax policy.

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