Permanent vs. Temporary Fiscal Expansion in a Two-Sector Small Open Economy Model

Abstract

This contribution shows that the duration of a fisscal shock together with sectoral capital intensity matter in determining the dynamic and steady-state effects in an intertemporal-optimizing two-sector small open economy model. First, unlike a permanent shock, net foreign asset position always worsens in the long-run after a transitory fiscal expansion. Second, steady-state changes in physical capital depend on sectoral capital-labor ratios but their signs may be reversed compared to the corresponding permanent public policy. Third, investment and the current account may now adjust non monotonically. Fourth, a temporary fiscal shock always crowds-out (crowds-in) investment in the long-run whenever the non traded (traded) sector is more capital intensive.