On the International Dimension of Fiscal Policy

Abstract

This paper analyzes the international dimension of fiscal policy in a small open economy framework. We consider the case in which the government finances its spending by levying distortionary taxes and issuing state‐contingent debt. While in a closed economy taxes are essentially invariant, in an open economy taxes can be as volatile as output. This is because the presence of a terms of trade externality introduces efficient fluctuations in the consumption–leisure wedge driven by movements in the real exchange rate. As a result, the optimal fiscal rule suggests that taxes should be varied to replicate these fluctuations.