Monetary policy in a small open economy with non-separable government spending

Abstract

PurposeDespite being a flexible tool that can address several macroeconomic issues, Dynamic Stochastic General Equilibrium (DSGE) models have been rarely used to analyse the interaction between monetary and fiscal policy until the post-financial crisis, leaving a gap in the analysis of how government consumption affects the transmission mechanism of monetary policy. This motivates this paper to analyse how government consumption affects the dynamics of a small open economy, once the former is included in a non-separable form to the utility function. To the best of the authors' knowledge, this issue has not been addressed by the literature, and the authors aim to do so in this paper.Design/methodology/approachA standard New Keynesian model for a small open economy is used to allow for the presence of non-separable government consumption in the utility function. The model is supported by panel regressions.FindingsThe inclusion of Government consumption dampens the transmission mechanism of monetary policy. The degree of openness dampens the crowding out effect of fiscal policy to monetary policy, as the exchange rate channel empowers it. Empirical estimates for 35 OECD countries support the theoretical findings of the model.Originality/valueThe effect of government consumption on the transmission mechanism of MP has not been addressed in the literature. This paper contributes to the literature by addressing this issue.Highlights:• The inclusion of Government consumption dampens the transmission mechanism of monetary policy.• The degree of openness alleviates the crowding out effect of fiscal policy to monetary policy, as the exchange rate channel empowers it.• Empirical estimates for 35 OECD countries support the theoretical findings of the model.