Structural and Stabilization Aspects of Fiscal and Financial Policy in the Dependent Economy

The paper considers the response of a small, open dependent economy to a variety of fiscal and financial shocks. It also examines the influence of alternative budget-balancing rules on the response of the economy to external shocks, such as a change in the world interest rate. The approach allows for both uncertain individual lifetimes and population growth, using a slightly generalized version of the Yaari-Blanchard model of consumer behaviour. Debt neutrality does not prevail unless the sum of the population growth rate and the individual's probability of death equals zero. The government spends on traded and non-traded goods and raises tax revenue both through a lump sum tax and through a distortionary tax on the production of traded goods. Even though the tax on the production of traded goods is the only conventional distortion in the model, changes in this tax rate will have first-order real income effects even when the distortion is evaluated at a zero tax rate, as long as the individual's subjective pure rate of time preference differs from the interest rate. This can occur even in well-behaved steady states of the Yaari-Blanchard model, as long as the sum of population growth rate and the probability of death differs from zero. This "intrinsic" distortion effectively causes second-best arguments to apply even when there is only one conventional distortion. Even in the absence of government budget deficits, fiscal choices relating to the composition of public spending and the structure of taxation have important short- and long-term consequences for the real exchange rate, the sectoral allocation of production, and the level and composition of private consumption. They also affect the current account in the short run and the nation's stock of claims on the rest of the world in the long run.