Financial constraints and the small open economy

Abstract

The thesis develops a new model of the small open economy emphasizing financial constraints, based on the notion of liquidity preference as a constraining tendency on the income adjustment process. Preference for liquid assets results in a number of financial states of constraint, such as financial vulnerability, financial exclusion and financial fragility. These are explored in a regional and international context. Openness brings with it new opportunity as well as potential constraints. Models of small open economies have in general assumed away the latter and have neglected the consequences of financial openness. This is reflected in the absence of a means to identify economies as small and open on the basis of their financial exposure. The financial vulnerability index is developed to address this deficit. Applied to twenty-one countries, the index reveals that emerging countries can be classified as small open economies constrained by preference for liquid assets. Policies designed with the conventional approach to constraints in mind appear to be inappropriate for these countries. The concept of constraints has rarely been dealt with explicitly and a possible categorisation of constraints for mainstream and Post Keynesian schools is developed. It proves to be a useful point of entry for grasping ontological differences between schools. It also provides insights into the constraining tendencies facing the small open economy, and how they can be managed. When these insights are applied to the South African economy, the current macroeconomic policy, and critiques thereof, are found to be wanting.