Fiscal Policy in Open Economies

Abstract

We argue that the significance of the exchange rate regime for the effectiveness of fiscal policy in small open economies has been exaggerated in the literature. Using the New Keynesian (NK) open economy model we demonstrate that the form of the domestic policy rule pursued under flexible rates and the degree of international capital mobility play a more important role. We investigate the effects of government spending shocks in 21 countries using a VAR identification scheme suggested by Fatás and Mihov, 2002. Consistent with the NK theory (and in contradiction to the IS-LM predictions), we find that the size of the fiscal multiplier does not vary systematically with the exchange rate regime. The degree of capital mobility and trade openness also seem to exert limited influence.