Fiscal Policy in Open, Interdependent Economies

The paper studies fiscal policy in the open economy. It proceeds from the very small country, which is a price taker in the world financial market and in the markets for imports and exports, via the semi-small country, which has some market power in the market for its exportable, to the interdependent two-country case. To keep the analysis tractable, a very simple production structure is assumed: each country consumes both domestic and foreign output but is wholly specialised in the production of its exportable. So as to be able to analyse ‘crowding out’ issues in the short run and the long run, firms in each country can engage in capital formation. Only domestic output can be transformed into domestic capital, and the investment process is subject to strictly convex internal costs of adjustment. There is no money in the model, but international portfolio lending and borrowing can occur in an integrated global financial market. There is no direct foreign investment. Rational point expectations and certainty equivalence are assumed throughout, so all stores of value are perfect substitutes in private portfolios. As cyclical, Keynesian issues are not the focus of this paper, full employment is assumed throughout.