Tax and monetary policy rules in a small open economy with disaggregated government purchases

This paper aims to evaluate the impact of tax and monetary policy rules with disaggregated government purchases on welfare, real exchange rate and business cycle in a small open economy using a new-Keynesian dynamic stochastic general equilibrium (DSGE) framework. The model generate the government purchases-real exchange rate puzzle. In this sense, an increase in both government consumption and investment depreciates the real exchange rate. Moreover, the decomposed government purchases have positive impact on welfare for any policy rules. There are three mechanisms by which the decomposed government purchases depreciate the exchange rate. Firstly, the public investment improves both the marginal productivity of labour and capital stock, which have a positive impact on labour supply, private capital stock, and output. The second channel is a direct effect of the government consumption on real exchange rate through international risk sharing. The third channel is the complement relationship between private consumption and government consumption.