On the International Dimension of Fiscal Policy

Authors


  • The authors would like to thank the World Economic and Finance program for the ESRC grant RES-165-25-0018 under which this research was supported. This work was largely carried out before the author joined the Bank of England, and the views expressed in this paper are those of the author and do not necessarily reflect the views of this institution.

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.

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