DP7232 On the International Dimension of Fiscal Policy

Author(s): Gianluca Benigno, Bianca De Paoli
Publication Date: March 2009
Keyword(s): fiscal policy, optimal policy, small open economy
JEL(s): E62, E63, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7232

This paper analyses the international dimension of fiscal policy using a small open economy framework in which the government finances its spending by levying distortionary taxation and issuing non-state-contingent debt. The main finding of the paper is that, once the open economy aspect of the policy problem is considered, it is not optimal to smooth taxes following idiosyncratic shocks. Even when prices are flexible and inflation can costlessly act as a shock absorber to restore fiscal equilibrium, the presence of a terms of trade externality lead to movements in the tax rate. Also in contrast with the closed economy, the introduction of sticky prices, can reduce the optimal volatility of taxes.