Macroeconomic Implications of Fiscal Policy in a Small Open Economy

Abstract

This dissertation deals with the macroeconomic implications of fiscal policy in small open economies with a particular emphasis on emerging economies. I use both empirical and theoretical approaches to distinguish key difference in the design of fiscal policy between emerging and developed economies. I also analyze the macroeconomic consequences of differences in the conduct of fiscal policy. Thus, the dissertation is focused on the interplay between fiscal policy and business cycle dynamics. Recent policy challenges in developed economies, such as monetary authorities grappling with the zero lower bound on short run nominal rates and fiscal stimulus packages emerging as an important policy tool, have sparked renewed academic interest in the topic of fiscal policy and business cycles. Institutional and macroeconomic features in emerging economies make the macroeconomic aspects of fiscal policy an important research agenda and one to which this dissertation contributes. A number of papers have documented fiscal policy pro-cyclicality in terms of stronger co-movement between government expenditure and macroeconomic fundamentals in emerging and developing economies. This feature of the data raises 2 important questions: 1) does fiscal policy reinforce the macroeconomic cycle in these countries leading to heighten macroeconomic volatility ("when it rains, it pours"), and 2) is the fiscal stance in these economies due to unique macroeconomic features or is it the consequence of institutional and political imperfections? The first chapter, titled "When it rains, it pours": fiscal policy, credit constraints and business cycles in emerging and developed economies, sets out to answer these questions by comparatively studying a group of developed and emerging economies. I estimate a panel structural vector autoregressive model to investigate if government consumption expenditure responds more pro-cyclically to fundamentals and what role international financial conditions play for the fiscal stance and for the volatility of the cycle in emerging and developed economies. My findings suggest that the response to output fluctuations is not systematically different for emerging governments relative to their developed counterparts. However, emerging governments curtail spending in response to increases in the sovereign borrowing rate which forces their consumption expenditure to act more pro-cyclically. I find evidence of higher fiscal discretion in emerging economies. However, the efficacy of government consumption expenditure is substantially lower in emerging than in developed economies. Thus, fiscal policy ends up being responsible for a lower share of business cycle volatility in emerging than in developed economies. In the second chapter, titled Estimating the Dynamics of Fiscal Financing in Emerging Economies, I propose a strategy for estimating the government financing rule for an emerging economy. The estimation uses the structural VAR impulse responses obtained in the previous chapter to discipline the parameters of a small open economy real business cycle model with a public sector. The parameters can be split into two groups: those influencing the effectiveness of fiscal policy and the parameters governing the financing of the exogenous stream of government consumption. The empirical response to interest rate shocks puts restrictions on the first group of parameters governing the size of the multiplier. The empirical response to a government consumption shock can be used to obtain estimates of the fiscal policy rule. I construct a model with a role for both interest rate shocks and government consumption shocks. A natural estimation approach in this case is impulse response matching.