Adjustment performance of open economies: some international comparisons
BIS Economic Papers No 10
The adjustment problems of small open economies have been a focal point of analysis for many years. Up to the early 1970s, discussion proceeded against a background of international developments dominated by demand shocks, which often originated in divergent and over-ambitious demand management policies and ultimately led to breakdown of the Bretton Woods regime. Thereafter, attention shifted as the world economy became subject mainly to supply shocks, including the commodity boom of 1972-73, the two oil shocks, large fluctuations in real and nominal exchange rates and, in the early 1980s, the emergence of unusually high interest rates internationally. Whereas in the first period, demand disturbances from abroad had affected inflation and unemployment in opposite directions, the second period brought an increase in inflationary pressures and a rise in unemployment at the same time.
These developments, of course, greatly complicated the task of formulating satisfactory adjustment policies, raising in particular the question of how, and at what speed, to respond to supply shocks. It may be observed that the change in underlying supply conditions was a gradual process which began during the second half of the 1960s, though the implications for and constraints on policy formation were less dramatic than in the case of the international price shocks in the early 1970s and were initially recognised in only a few countries. The change may be attributed to both a gradual build-up of inflationary expectations and a slowing-down of productivity growth. It can, therefore, also be interpreted as a "supply side" phenomenon and probably lies behind the steepening slope of the price-output curves evidenced in practically all the industrial countries during the post-war period.
Two further developments which have strongly conditioned policy formation in small open economies have been the generalised move to more flexible exchange rates in the early 1970s and the subsequent adoption in some major countries of targets for the growth of the monetary aggregates. In this environment, and given their openness both as price-takers and in regard to capital movements, small open economies have, with certain exceptions, generally preferred to fix their currencies in relation to that of some larger trading partner rather than to adopt a monetary target. Although the hard-currency option tends to provide a stabilisation pivot for their policies, it may also set constraints that are at times too stringent for the country to cope with.
The stylised model of the small open economy has been the subject of a great deal of theoretical analysis. At the empirical level, of course, there are important differences in the economic position and policy experience of individual countries. At least four differences seem to be of major importance: degree of openness, vulnerability to particular kinds of external shocks, institutional factors and policy responses. Obviously, it is of considerable potential interest to compare the experience of different countries with a view to learning the lessons of developments over the past fifteen years. In particular, it is useful to see to what extent rigidities - due to institutional factors, behavioural patterns or past policy measures - have influenced the adjustment process and thereby either hampered or facilitated the implementation of effective policies. We have chosen for this purpose four countries: Austria, Belgium, Canada and Sweden - a more or less random selection of open economies whose experience, though similar in some respects, has differed widely in others.