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On the international dimension of fiscal policy

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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.

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en

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http://eprints.lse.ac.uk/33344/

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