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On the International Dimension of Fiscal Policy
Author(s) -
BENIGNO GIANLUCA,
DE PAOLI BIANCA
Publication year - 2010
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/j.1538-4616.2010.00352.x
Subject(s) - economics , small open economy , fiscal policy , consumption (sociology) , externality , open economy , monetary economics , dimension (graph theory) , government spending , debt , macroeconomics , exchange rate , microeconomics , market economy , welfare , social science , mathematics , sociology , pure mathematics
This paper analyzes the international dimension of fiscal policy in a small open economy framework. We consider the case in which the government finances its spending by levying distortionary taxes and issuing state‐contingent debt. While in a closed economy taxes are essentially invariant, in an open economy taxes can be as volatile as output. This is because the presence of a terms of trade externality introduces efficient fluctuations in the consumption–leisure wedge driven by movements in the real exchange rate. As a result, the optimal fiscal rule suggests that taxes should be varied to replicate these fluctuations.