Underlying characteristics and macroeconomic policies
The size of the economies of small states and territories—ministates for short—imposes particular constraints on the conduct of their monetary, exchange rate, and related policies. It is instructive to examine these constraints, both to illustrate the specific problems of ministates, on which virtually no research has been done, and to test and extend the policy implications of the large body of economic literature that deals with small open economies. In dealing with the smallest of all economies one expects to capture these implications in their clearest and strongest form.
The sample countries included in this study were the Bahamas, Bahrain, Barbados, Botswana, Cape Verde, the Comoros, Cyprus, Djibouti, Dominica, Equatorial Guinea, Fiji, Gabon, The Gambia, Grenada, Guinea-Bissau, Guyana, Iceland, Luxembourg, Maldives, Malta, Mauritius, Netherlands Antilles, Oman, Qatar, Sao Tome and Principe, Seychelles, Solomon Islands, St. Lucia, St. Vincent, Suriname, Swaziland, Vanuatu, and Western Samoa.
For the purposes of this article, which is based on a more detailed study by the author, ministates are defined as states and territories that have a population of less than one million people. Of course, other definitions would be possible for other purposes. This definition allows the investigation of the various macroeconomic implications of smallness, irrespective of a country’s stage of development, that cannot be captured by either the standard approach, which defines smallness in terms of price-taking behavior, or by a definition in terms of a macroeconomic variable, such as GNP.
Defining a country to be small if it cannot influence world prices for goods and assets involves the obvious problem that virtually all countries are price-takers, and hence small in this sense. This difficulty arises because price-taking is only one of the likely economic characteristics of smallness; the degree of openness to trade and to capital movements, and export dependence are others that bear directly on the conduct and effectiveness of economic policies in ministates. Nevertheless, the study utilizes some analytical insights of the literature on small open economies concerning the effects of substantial interest rate and price adjustment. The study uses a general macroeconomic model of a small open economy capable of capturing the underlying structural characteristics to illustrate the main propositions. A practical problem with defining smallness in terms of some direct macroeconomic variable, such as real GNP, capital, or the labor force, is the lack of data, particularly on the capital stock and the labor force. More important, such a definition would, ceteris paribus, tend to exclude the more developed countries and, therefore, frustrate the investigation of whether different development stages have an effect on the conduct of policies in mini-states.
The cut-off point of one million people in this definition of small size is somewhat arbitrary. The main justification is that while there are about 100 small states and territories of less than one million people—the majority of them islands or located in islands—there are only about a dozen with a population of between one and two million people and even fewer in the higher ranges. For empirical material this paper draws principally on a sample of 33 mini-states that are members of the Fund.
The two main conclusions of the study are, first, that ministates, in their pursuit of domestic stabilization goals, have generally been assisted by the adoption of stable effective exchange rates; and, second, that they are likely to benefit from an accommodating monetary policy (i.e., domestic credit and interest rate policies) designed to maintain the stability of the exchange rate. The limited scope of exchange rate and monetary policies in ministates is related to their basic structural characteristics: substantial openness to trade and financial capital, dependence on a few exports, price-taking behavior with its attendant vulnerability to large real economic shocks, and the likelihood that wages will rise with inflation but will be inflexible downward. A related conclusion is that ministates have to be especially careful to avoid large public sector deficits and excessive factor income demands in relation to GNP, which make the appropriate conduct of exchange rate and monetary policies difficult. These conclusions do not apply exclusively to ministates; they may also apply, although perhaps less certainly, to a number of relatively larger countries, particularly developing ones, that share some of the underlying characteristics of ministates.