Optimal Government Spending in a Collateral-Constrained Small Open Economy

Masashige Hamano and Yuki Murakami

No 2401, Working Papers from Waseda University, Faculty of Political Science and Economics

Abstract: This paper investigates the stabilization role of government spending in a collateral constrained small open economy. The economy is characterized by inefficiencies in borrowing decisions, resulting from pecuniary externalities and the amplification mechanism of the debt-deflation spiral. In this context, government spending serves to maintain financial stability, extending beyond the efficient provision of public goods. When the economy borrows up to its limit, the optimal response is fiscal stimulus, which mitigates the amplification of the debt-deflation mechanism. The optimal time-consistent policy prevents recessionary shocks from leading to a financial crisis accompanied by a drastic reversal of the current account. We show that an implementable government spending policy, which maintains a constant ratio to GDP, approximates the optimal policy and achieves a second-best outcome.

Keywords: Small open economy; financial crises; optimal government spending (search for similar items in EconPapers)
Pages: 28 pages
Date: 2024-04
New Economics Papers: this item is included in nep-dge, nep-fdg and nep-opm
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Working Paper: Optimal Government Spending in a Collateral-Constrained Small Open Economy (2025)
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Persistent link: https://EconPapers.repec.org/RePEc:wap:wpaper:2401

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