Stabilization policy in an open economy

The scope for an active demand management policy is considered for a small open economy. Business cycle fluctuations generated by supply and demand shocks are shown to imply welfare losses when agents are risk averse and the capital market incomplete. Public demand for non-tradeables has real effects and there is a welfare case for pursuing a demand management policy which stabilizes consumption. It is argued that this type of stabilization can be attained via automatic stabilizers based on nominal budgeting rules. (C) 2002 Elsevier Science Inc. All rights reserved.