Assessing economic vulnerability and resilience in a DSGE framework

Abstract

The analysis of vulnerable economies is established in the literature and it has been shown that small states especially are inherently vulnerable given their smallness and openness. Despite this, a number of success stories have been documented, proving that with the implementation of the right policies, these small states can develop an ability to withstand or recover from the negative effects of economic shocks. This work aims to capture the concepts of economic vulnerability and resilience in a framework which nowadays is considered to lie at the forefront of macroeconomic modelling. A Dynamic Stochastic General Equilibrium (DSGE) model of a small, open economy is used to assess the implications of vulnerability, and the effects of different policies that counter such vulnerability, in order to understand the dynamics behind the adjustment processes in small states. It is shown that a relatively simple model is able to replicate the dynamics implied by the data for the Maltese economy to a reasonable degree and the results indicate a preference towards one type of government policy over another. In line with other studies, it is argued that such a policy can only be afforded if the economy is willing to save and thus accumulate resources that it can utilise in times of distress.