Direct effects of public spending on private spending in a small open economy model with variable prices

Abstract

In recent years a number of investigators, noatbly Aschauer (1988, 1989a, 1989b), Barro (1981, 1990), Barth and Cordes (1980), Blejer and Khan (1984), Calderon (1988), Cardoso (1993), Munnell (1990), Ram (1986), Ramirez (1991, 1993) and Riedel (1992), have investigated both conceptually and empirically the direct effects of public spending on private expenditures. This paper extends the scope of their analyses by explicitly showing how the inclusion of the government variable in the private consumption and investment functions changes the nature of fiscal policy in an open economy with variable domestic prices. Throughout the analysis, a systematic effort is made to compare the differing effects of fiscal policy in the standard and modified models under both fixed and flexible exchange rate regimes. This paper is organized as follows. First, a theoretical rationale for including the government sector as an argument in the private consumption and investment functions is provided. Next, the paper examines the impact of fiscal policy in the fixed rate case under both imperfect and perfect mobility. It is shown that when public and private spending are compliments, conventional policies for stabilizing the economy may lead to chronic stagflationary pressures. Under these conditions, it is expedient for policymakers to recognize that varying the compostion of public spending-independent of its amount-may lead to a stable assignment. Third, the paper examines the impact of changes in both the level and composition of government spending on relevant targets on the flexible rate case with perfect capital mobility. The paper is brought to a close by investigating the assignment problem in the modified model for the flexible rate case. It is shown that government officials may prescribe potentially destabilizing policies if they mistakenly believe that they are operating in the conventioanl model. The last section summarizes the major findings and offers some concluding observations. © 1997 by John Wiley & Sons, Ltd.