Abstract
ABSTRACTRecent empirical findings attribute a central role to the degree of economic openness to determine the size of the fiscal multiplier. See, for instance, Ilzetzki et al. (2013) [How big (small?) are fiscal multipliers? Journal of Monetary Economics, 60(2), 239–254]. However, traditional macroeconomic models have difficulties to account for this evidence. By introducing ‘deep-habit’ formation into a New Keynesian small open economy model, this paper provides a theoretical framework which is able to attest for the new empirical evidence. Deep habits give rise to counter-cyclical firm markups, which are crucial to generate effects of openness on the fiscal multiplier as found in the data. We study three dimensions of economic openness: exchange rate flexibility, trade openness, and capital mobility. In line with the empirical findings, we report a negative relationship between measures of economic openness and the fiscal multiplier.
Highlights
Central contributions to macroeconomic research have been dedicated to the effect of fiscal stimulus on the business cycle, which is a topic of vital relevance in the face of the recent global crisis. Ramey (2011) provides a survey of empirical literature, summarizing that fiscal multipliers have been estimated to lie essentially between 0.8 and 1.5, depending on the setting and the method of estimation.1 While the responses of output and consumption to an increase in government spending have weakened over the past three decades, as it is reported by Canzoneri, Collard, Dellas, and Diba (2009), globalization at the same time has made economies increasingly interdependent
This paper analyzes the implications of openness to trade, capital mobility, and exchange rate flexibility for the fiscal multiplier
The resulting substitution effect for households creates a positive response of consumption to a fiscal shock
Summary
Central contributions to macroeconomic research have been dedicated to the effect of fiscal stimulus on the business cycle, which is a topic of vital relevance in the face of the recent global crisis. Ramey (2011) provides a survey of empirical literature, summarizing that fiscal multipliers have been estimated to lie essentially between 0.8 and 1.5, depending on the setting and the method of estimation. While the responses of output and consumption to an increase in government spending have weakened over the past three decades, as it is reported by Canzoneri, Collard, Dellas, and Diba (2009), globalization at the same time has made economies increasingly interdependent. Dellas, Neusser, and Walti (2005) identify a positive effect of capital mobility on the fiscal multiplier. Two groups of authors stand out with their contributions to estimating empirically the effect of economic openness on the fiscal multiplier. Ilzetzki, Mendoza, and Vegh (2010) apply a structural VAR approach, providing evidence of both openness to trade and exchange rate flexibility being negatively related with fiscal effectiveness. Both of these studies are based on a panel of OECD countries. Both of these studies are based on a panel of OECD countries. Ilzetzki et al (2010) consider developing countries in addition
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