Financial Integration, Productive Development and Fiscal Policy Space in Developing Countries

This paper presents a simple post-Keynesian model, which highlights the importance of productive development in defining the dynamics of the Real Exchange Rate (RER) and foreign debt in a small open developing economy. In developing countries that are integrated in international financial markets, capital flows and fluctuations in the RER endogenously feed back into each other and give rise to cyclical macroeconomic volatility. Fiscal austerity supposedly taming external imbalances exacerbates such instability. More diversified productive structures open more space for expansionary fiscal policies, make the economy more resilient to finance-led macroeconomic cycles, and make external debt more sustainable. Capital controls together with stronger price sensitivity of net exports can further stabilize the economy. The paper provides support to the combination of industrial and macroprudential policies in peripheral economies to foster productive diversification, which is turn critical to sustain macroeconomic stability in the short and the long run