Economic Openness and Fiscal Multipliers

Riguzzi, Marco; Wegmüller, Philipp (February 2016). Economic Openness and Fiscal Multipliers (Discussion Papers 15-04). Bern: Department of Economics

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Recent empirical findings attribute a central role to the degree of economic openness to determine the size of the fiscal multiplier. See for instance Ilzetzki, Mendoza & Végh (2013). However, traditional macroeconomic models have difficulties to account for this evidence. By introducing ‘deep-habit’ formation into a New Keynesian small open economy model, this paper provides a theoretical framework which is able to attest for the new empirical evidence. Deep habits give rise to counter-cyclical firm markups, which are crucial to generate effects of openness on the fiscal multiplier as found in the data. We study three dimensions of economic openness: Exchange rate flexibility, trade openness and capital mobility. In line with the empirical findings, we report a negative relationship between measures of economic openness and the fiscal multiplier.

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