Policies for Stabilization and Growth in Small Very Open Economies

Small very open economies are different from large economies, in that they face a foreign exchange constraint that cannot be alleviated by depreciation of the real exchange rate or other policy. This constraint affects monetary, fiscal and exchange rate policy; fiscal sustainability and debt management; and patterns of economic growth. With respect to monetary/fiscal/exchange rate policy, the most accessible framework for such economies is an exchange rate anchor, where the foreign currency market is balanced by managing aggregate demand, using fiscal policy. With respect to debt, the most sensitive indicators of fiscal sustainability are the ratio of external debt service to foreign earnings, and the rollover risk on foreign currency loans. With respect to growth, expansion in the small open economy is sustainable only if led by the sectors that earn or save foreign exchange