DP7535 Cross-border spillovers from fiscal stimulus
The global recession of 2008-09 has revived interest in the international repercussions of domestic policy choices. This paper focuses on the case of fiscal stimulus, investigating cross-border spillovers from an increase in exhaustive government spending on the basis of a two-country business cycle model. Our model allows spillovers to be affected by a range of features, including trade elasticities, the size and openness of economies, as well as financial imperfections. Beyond these well-known determinants, however, we highlight the central importance of policy frameworks, notably the medium-term debt consolidation regime. We consider the plausible case in which a temporary debt-financed increase in government spending gives rise to higher future taxes along with some reduction in spending over time. The anticipated spending reversal not only strengthens the domestic stimulus effect but also enhances positive cross-border spillovers through its impact on global long-term interest rates. Thus, our findings lend support to the notion that coordinated short-term stimulus policies are most effective when coupled with credible medium-term consolidation plans featuring at least some spending restraint.