The Effects of Fiscal Policy in a Small Open Economy with a Fixed Exchange Rate

We study the empirical effects of fiscal policy in Denmark since the adoption of a fixed exchange rate policy in 1982. Denmark’s fixed exchange rate implies that the nominal interest rate remains fixed after a fiscal expansion, facilitating a substantial impact of the fiscal stimulus on the real economy. On the other hand, the large degree of openness of the Danish economy means that a sizeable share of the fiscal stimulus will be directed towards imported goods. Our results suggest that the ‘monetary accomodation channel’ dominates the ‘leakage effect’ in the short run. We demonstrate that fiscal stimulus has a rather large impact on economic activity in the very short run, with a government spending multiplier of 1.1 on impact in our preferred specification. We also find that the effects of fiscal stimulus are rather short-lived in Denmark, with the effect on output becoming insignificant after around two years. The fiscal multiplier is above 1 only in the first quarter, and drops to 0.6 one year after the shock. We also find that in the short run, the government spending multiplier is larger than the tax multiplier. Finally, we demonstrate that exogenous shocks to government spending account for less than 10 % of the movements in output over the business cycle in Denmark. Copyright Springer Science+Business Media New York 2014