Abstract
This paper studies the welfare effects of a consumption tax rise based on the two-sector small open economy model of Obstfeld and Rogoff (1995) and Lane (1997). The main findings of our analysis are that 1) in the case of free trade, the consumption tax rise has no effect on welfare, 2) when there is the nontraded goods sector, the consumption tax rise has a negative effect on welfare, and 3) the larger the share of nontraded goods in consumption is, the larger the negative welfare effect of consumption tax will be.
Highlights
In the new open economy macroeconomics literature pioneered by Obstfeld and Rogoff [1], the relationship between monetary expansions and aggregate economic activity has been studied extensively at the theoretical level.1 This literature has focused on how the macroeconomic activity and welfare of multiple countries are influenced by unanticipated monetary shocks in one country under monopolistic distortions and price rigidities
The main findings of our analysis are that 1) in the case of free trade, the consumption tax rise has no effect on welfare, 2) when there is the nontraded goods sector, the consumption tax rise has a negative effect on welfare, and 3) the larger the share of nontraded goods in consumption is, the larger the negative welfare effect of consumption tax will be
Under free trade, the consumption tax rise has no effect on welfare
Summary
In the new open economy macroeconomics literature pioneered by Obstfeld and Rogoff [1], the relationship between monetary expansions and aggregate economic activity has been studied extensively at the theoretical level. This literature has focused on how the macroeconomic activity and welfare of multiple countries are influenced by unanticipated monetary shocks in one country under monopolistic distortions and price rigidities. Lane [5] extends the small open economy model in Obstfeld and Rogoff [1] to include government behavior and shows how variation in trade openness affects the welfare effects of expansionary monetary policy shocks. The purpose of this paper is to contribute theoretically to the new open economy macroeconomics literature by generalizing the small open economy model of Obstfeld and Rogoff [1] and Lane [5] to include a consumption tax rate and examining the question of how the degree of trade openness (or the share of nontraded goods in consumption) affects the response of welfare to an increase in the consumption tax rate.
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