The Effects of Government Spending in a Small Open Economy within a Monetary Union

73 Pages Posted: 26 Aug 2014

See all articles by Daragh Clancy

Daragh Clancy

European Stability Mechanism

Pascal Jacquinot

European Central Bank (ECB)

Matija Lozej

European Central Bank (ECB); Central Bank of Ireland; University of Primorska

Date Written: August 13, 2014

Abstract

Small open economies within a monetary union have a limited range of stabilisation tools, as area-wide nominal interest and exchange rates do not respond to country-specific shocks. Such limitations imply that imbalances can be difficult to resolve. We assess the role that government spending can play in mitigating this issue using a global DSGE model, with an extensive fiscal sector allowing for a rich set of transmission channels. We find that complementarities between government and private consumption can substantially increase spending multipliers. Government investment, by raising productive public capital, improves external competitiveness and counteracts external imbalances. An ex-ante budget-neutral switch of government expenditure towards investment has beneficial effects in the medium run, while short-run effects depend on the degree of co-movement between private and government consumption. Finally, spillovers from a fiscal stimulus in one region of a monetary union depend on trade linkages and can be sizeable.

Keywords: fiscal policy, public capital, imbalances, trade

JEL Classification: E22, E62, H54

Suggested Citation

Clancy, Daragh and Jacquinot, Pascal and Lozej, Matija and Lozej, Matija, The Effects of Government Spending in a Small Open Economy within a Monetary Union (August 13, 2014). ECB Working Paper No. 1727, Available at SSRN: https://ssrn.com/abstract=2479951 or http://dx.doi.org/10.2139/ssrn.2479951

Daragh Clancy (Contact Author)

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Pascal Jacquinot

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Matija Lozej

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Central Bank of Ireland ( email )

Dame Street
Dublin, 2
Ireland

University of Primorska ( email )

Glagoljaska 8
Koper, SI-6000
Slovenia

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