Monetary Policy in a Small Open Economy with Non-Separable Government Spending

To show how fiscal policy affects the transmission mechanism of monetary policy, we extend a standard new Keynesian model for a small open economy to allow for the presence of non-separable government consumption in the utility function. We show how monetary policy should optimally respond to demand and supply shocks when the government sector is incorporated into the model. The introduction of government consumption affects the transmission of monetary policy. When government consumption has a crowding in effect on private consumption, it will dampen the transmission mechanism of monetary policy, and vice versa. Nevertheless, the degree of openness will minimise the effect of the introduction of government consumption in a non-separable form. Data for 35 OECD countries empirically support these findings, and the empirical results are robust to the zero lower bound period. The theoretical model also shows that, once we model the rest of the world economy, domestic government consumption and foreign government consumption will have opposing effects on private consumption, which contradicts with the existing literature.