A small country with open capital markets is particularly vulnerable to any uncertainty about its future monetary policy. This seems to be the commonly held view of journalists and other commentators on macroeconomic affairs. There is a considerable literature on theoretical models of open economies with various types of uncertainty and a wide range of types of asset. Most of this literature has assumed that goods and labour markets function perfectly, in that prices are assumed to be flexible and markets clear instantaneously. This introduces a strong bias towards the neutrality of monetary factors for real macroeconomic variables.

In Discussion Paper No. 1231, Research Fellow Neil Rankin develops a model the structure of which is carefully built up from optimizing behaviour by agents, complete with rational expectations. In this respect, it is much closer to papers in the finance literature. The paper incorporates a simplified version of a closed-economy model, in which the world is represented as consisting of two qualitatively symmetric countries, one infinitely larger than the other, so that the large country is effectively a closed version of the small country. This is necessary from a technical point of view, since it enables the author to determine the composition of agents' portfolios in the open economy once the composition in the closed economy is known, by arguing that the same portfolio will be held in both countries. This `pooled' portfolio property allows the model to be solved analytically, without the need for linear approximations as typically used in the somewhat related `real business cycle' literature. The main finding is that whereas in the closed economy an anticipated increase in monetary variability has no effect on current macroeconomic variables, in the small open economy it weakens the current exchange rate and expands current output.

Nominal Rigidity and Monetary Uncertainty in a Small Open Economy
Neil Rankin

Discussion Paper No. 1231, August 1995 (IM)