Anchoring the Exchange Rate in the Small Open Economy: Why and How?

We propose an integrated fiscal and monetary approach to economic stabilisation policy in small open financially integrated economies (SOFIE’s), using fiscal policy to achieve external balance at a targeted exchange rate. This approach overcomes the conundrum of the conventional Mundell-Fleming view, in today’s world of international financial integration, where capital controls do not insulate the small domestic economy, and where local authorities cannot be indifferent to the volatility of the exchange rate of local currency, and the potential harm to savings, investment, capital flight and domestic financial stability. In today’s world, the standard prescription of flexible exchange rates and independent monetary control targeting inflation presents challenges with which SOFIE’s have struggled, with little success. We describe the framework for an alternative which suits the circumstances of SOFIE’s.