Stabilization policy in an open economy Torben M. Andersen a, * , Steinar Holden b a Department of Economics, School of Economics and Management, University of Aarhus, Building 350, DK-8000, Aarhus, Denmark b Department of Economics, University of Oslo, Box 1095 Blindern, 0317 Oslo, Norway Received 3 January 2001; accepted 13 July 2001 Abstract The scope for an active demand management policy is considered for a small open econ- omy. 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 manage- ment policy which stabilizes consumption. It is argued that this type of stabilization can be attained via automatic stabilizers based on nominal budgeting rules. Ó 2002 Elsevier Science Inc. All rights reserved. JEL classification: E32; E63; F41 Keywords: Stabilization policy; Fiscal policy; Aggregate risk; Social insurance 1. Introduction For more than a decade, reducing public budget deficits has been the overriding concern for fiscal policy analysis, and other issues have been devoted little attention. Yet in the last few years budget deficits have been reduced significantly in many in- dustrialized economies, and while long-term issues related to pensions and demo- graphic trends are still a matter of deep concern, more attention can again be given to the short-run effects of fiscal policy. However, much of the existing economic literature on fiscal policy is based on rather restrictive models that do not apply to * Corresponding author. E-mail addresses: tandersen@econ.au.dk (T.M. Andersen), steinar.holden@econ.uio.no (S. Holden). URLs: http://www.econ.au.dk/vip_htm/tandersen/homepage.htm, http://folk.uio.no/sholden. 0164-0704/02/$ - see front matter Ó 2002 Elsevier Science Inc. All rights reserved. PII:S0164-0704(02)00039-3 Journal of Macroeconomics 24 (2002) 293–312 www.elsevier.com/locate/econbase