Dynamic General Equilibrium modelling of tiny countries

Fiscal Policy Multipliers in Small States

By Ali Alichi, Ippei Shibata and Kadir Tanyeri


Government debt in many small states has risen beyond sustainable levels and some governments are considering fiscal consolidation. This paper estimates fiscal policy multipliers for small states using two distinct models: an empirical forecast error model with data from 23 small states across the world; and a Dynamic Stochastic General Equilibrium (DSGE) model calibrated to a hypothetical small state’s economy. The results suggest that fiscal policy using government current primary spending is ineffective, but using government investment is very potent in small states in affecting the level of their GDP over the medium term. These results are robust to different model specifications and characteristics of small states. Inability to affect GDP using current primary spending could be frustrating for policymakers when an expansionary policy is needed, but encouraging at the current juncture when many governments are considering fiscal consolidation. For the short term, however, multipliers for government current primary spending are larger and affected by imports as share of GDP, level of government debt, and position of the economy in the business cycle, among other factors.

Policy Trade-Offs in Building Resilience to Natural Disasters: The Case of St. Lucia

By Alessandro Cantelmo, Leo Bonato, Giovanni Melina and Gonzalo Salinas


Resilience to climate change and natural disasters hinges on two fundamental elements: financial protection —insurance and self-insurance— and structural protection —investment in adaptation. Using a dynamic general equilibrium model calibrated to the St. Lucia’s economy, this paper shows that both strategies considerably reduce the output loss from natural disasters and studies the conditions under which each of the two strategies provides the best protection. While structural protection normally delivers a larger payoff because of its direct dampening effect on the cost of disasters, financial protection is superior when liquidity constraints limit the ability of the government to rebuild public capital promptly. The estimated trade-off is very sensitive to the efficiency of public investment.

I have always been fascinated with tiny countries (think: Caribbean states) and how they can operate. This week’s crop of the NEP-DGE report has by coincidence two papers about such countries. The first looks at an “average” tiny country and how fiscal multipliers work in various circumstances, while the second one studies specifically St. Lucia (population 182K). The advantage of DSGE modelling is that it can work in a data-poor environment. No need for long time series, and guesses can make do if data is missing entirely. In fact, long-term averages are often sufficient.


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