Gordon Cordina
University of Malta

• Economic behaviour is conditioned not only by levels but also by potential variability (risk)
• Variability has implications for the long term growth and short run macroeconomic dynamics of a country
• Small economies are usually more prone to shocks

– Exposure to exogenous shocks arising out of inherent characteristics of an economy
– Nurtured ability to withstand, absorb or rebound from the negative effects of shocks

• Stylised facts regarding the economic behaviour of small states in relation to their vulnerability
• Modelling the economic growth of vulnerable economies
• Modelling short run aggregate demand fluctuations of vulnerable economies
• Conclusions

Cordina G., The Dynamics of Growth and Macroeconomic Fluctuations of
Small States , in Small States: Economic Review and Basic Statistics,
Volume 12, Commonwealth Secretariat, March 2008.

Stylised Facts
• Small states, though not a homogenous group, are characterized by a number of common factors which impinge on their economic behaviour
• Common characteristics are here derived as stylised facts from literature and empirical observation
• Utilization of stylized facts as a first step towards developing positive theories in economics originated by Kaldor (1961)
Approach has limitations but is effective to perform empirical and theoretical analyses

Stylised Facts
• No general agreement on the definition of a ‘small’ economy
• Definitions may be behavioural and quantitative
• Behavioural definitions:
- price taker, limited resources and economies of scale and scope, etc (Briguglio, 1995; 2002)
• Quantitative definitions:
- population (Srinavasan, 1986), land area, total output, share in world trade
• Quantitative are more practicable than behavioral but require cut-off value
• Population is the most frequently used measure
• Size here considered as a continuous function of population rather than a discrete phenomenon

Stylised Fact 1:
Vulnerability is a relevant concept and small states, especially if insular, are likely to exhibit higher degrees of economic vulnerability than larger countries, either by being relatively more exposed to shocks and/or by being more susceptible to the effects of such shocks.

Stylised Fact 2:
Economic smallness and vulnerability is not associated with under-development. However, small vulnerable countries tend to exhibit a wider dispersion in their per capita incomes from a cross-sectional perspective.

Stylised Fact 3:
On average, small vulnerable countries do not exhibit different medium term growth rates compared to larger states. However, economic smallness and vulnerability tend to be associated with an increased volatility in per capita income growth over time.

Stylised Fact 4:
Small and by implication vulnerable countries typically allocate a larger portion of their output to investment than larger countries.

Stylised Fact 5:
Small vulnerable countries typically have larger cross-sectional differences in investment to
GDP ratios than large countries.

Stylised Fact 6:
Economic smallness and by implication, vulnerability is associated with higher fluctuations in aggregate demand and its components over time particularly in the induced elements.

Stylised Fact 7:
Economic smallness and vulnerability is associated with a higher reliance on imports to satisfy expenditure needs and on exports to service import expenditure.

Stylised Fact 8:
Economic smallness and by implication, vulnerability is associated with a higher likelihood of persistence of deficits on the external current account.

Stylised Fact 9:
Economic smallness and by implication, vulnerability is associated with a larger share of government expenditure within aggregate demand.

Stylised Fact 10:
There is no increased tendency for small states to register higher fiscal deficits in spite of the more pronounced dependence of such states on government expenditure and their overall proneness to current account deficits.

Stylised Fact 11:
Small vulnerable countries tend to have unemployment rates that are higher and more volatile over time than larger countries. There appear to be no marked differences in inflation rates and in their volatility over time between countries of different size.

Cordina G., Economic Vulnerability and Economic Growth: Some Results from a Neo-Classical Growth Model, Journal of Economic Development, vol.42 Dec 2004

- Convergence of per capita output between countries at different levels of development occurs at a slow pace
- Total factor productivity growth is larger and more volatile in small developing countries
- Examines the proneness of countries to exogenous shocks
- The impact of vulnerability to shocks on economic performance depends on resilience

Diminishing Marginal Productivity and Resilience
Resources Used
Negative shocks have stronger effects than symmetric positive ones. Vulnerability has adverse effects due to insufficient resilience.

Higher capital accumulation and per capita output (if permitted by economic framework): f’(k) + 0.5f’’’(k) s
2 k
= n + d + q
Rate of return on capital is higher in vulnerable countries because investment builds resilience
Lower per capita consumption: c = f(k) + 0.5f’’(k) s
2 k
– (n+d)k
Slows down convergence between developed and developing economies

Steady State Properties of the Baseline and
Vulnerability Models
Baseline Model c=c(k)
Baseline Model k
Vulnerability Model c=c(k)
Vulnerability Model k k

Speed of Convergence of Output to Steady State
Baseline
Tim e
Vulnerability

Rational Expectations:
-Smooth aggregate demand based on permanent income considerations assuming rationality and perfect markets
Keynesian:
-Fluctuating aggregate demand in response to expenditure shocks as reflected in the multiplier process due to market imperfections including:
Price rigidity
Disequilibrium between saving and investment
Role of interest rates

Baseline Rational Expectations Result:
Consumption is smooth over time and dependent only on permanent, and not current, income.
Hence there are no multiplier effects on aggregate demand.

Introducing vulnerability by means of shocks to future income:
The certainty equivalent of future income is lower than the expected value, depending upon the expected shocks and the degree of risk aversion. Hence, total consumption would be lower, reflecting precautionary saving.
With future income terms approaching zero, consumption would be influenced mainly by current income.

This implies the existence of Keynesian multiplier effects.
It can be further shown that these effects would be higher:
-as the planning horizon becomes shorter
-in response to positive compared to negative current income shocks (pre-cautionary saving was in the first place effected to cushion against negative income shocks)

Positive shocks thus increase aggregate demand by more than negative shocks would depress it.
This response runs counter to aggregate supply reactions.
Hence, there would be a proneness to excess aggregate demand situations, reflected in deficits on the external current account.

Baseline Rational Expectations Result:
Imports are a residual between aggregate demand and supply, without being necessarily related to any of these variables.
Imports would thus reflect demand and supply shocks, subject to an imposed constraint of long run current account sustainability.

Introducing vulnerability by means of shocks to the outputs of different productive sectors of the economy:
Diversification in different sectors would induce a measure of insurance against shocks.
But excessive diversification would entail little specialisation and resilience within each sector.
Optimal solution entails diversification in a few uncorrelated, or ideally negatively correlated sectors.

In small economies, such specialisation entails a structural dependence on exports and imports, mainly due to indivisibilites in production.
Small economies would thus tend not to be self-sufficient, and dichotomous in production, with part of the productive base entirely dedicated to the export sector.
This would tend to amplify exposure to shocks, also because of the specialisation in unrelated sectors.
Imports would be mainly dependent on demand in a manner similar to consumption expenditure, thereby corroborating the proneness to external deficits.

Due to the Keynesian nature of the economy subject to vulnerability, there is a greater role for fiscal policy in aggregate demand management.
Government would optimally mitigate fluctuations in aggregate demand through:
-counter-cyclical intervention
-absorbing a larger share of total expenditure

Other reasons for a relatively large government expenditure in small economies include:
-greater incidence of market failure
-indivisibilities in expenditure
Fiscal policy is thus of greater importance in vulnerable economies, leading to the risk of government failure.

• Vulnerability has important effects on long run growth patterns
• Vulnerability renders economic behaviour to be better explainable by Keynesian economics
• Sufficient reasons to conclude that mainstream theoretical approaches in economics to be revised for small economies, in the light of effects of exposure to shocks

Policy focus on resilience-building, which delivers a double dividend in also promoting economic growth.
• Resilience-building to be based on enhancing flexibility and increasing marginal productivity of productive factors.
• Important role for fiscal policy in vulnerable economies, with the consequent imperative of avoiding government failure.
• Key focus on international competitiveness to overcome proneness to external deficits.
• These issues have national and supra-national dimensions.