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Government Spending during Sudden Stop Crises

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  • Siming Liu

    () (Indiana University)

Abstract

This paper studies the effect of government spending policy during sudden stop crises. Using a quarterly dataset of 30 small open economies, I find that government spending is more effective in stimulating consumption and appreciating the real exchange rate during sudden stops than during normal times. To rationalize this, I build a two-sector model with a collateral constraint on external debt. During a recession, an adverse international shock reduces consumption and undermines the value of collateral. The collapsing asset price in turn tightens the financial constraint, deteriorates the real absorption, and sets-in a fully-blown debt-deflation mechanism. In this context, an increase in government purchases exerts a counteracting force by raising asset prices and stimulating real activities. More importantly, if the government can commit to certain paths of spending in the future, the expected real appreciation will further relax the financial constraint today. I use a calibrated model to explore the multiplier effect under different exchange rate regimes, the asymmetric multipliers, and the multipliers under different levels of shock persistence.

Suggested Citation

  • Siming Liu, 2018. "Government Spending during Sudden Stop Crises," CAEPR Working Papers 2018-002, Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington.
  • Handle: RePEc:inu:caeprp:2018002
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    File URL: https://caepr.indiana.edu/RePEc/inu/caeprp/CAEPR2018-002.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Spending Multiplier; Sudden Stop Crisis; Fisher's Debt-Deflation; Collateral Constraint; Downward Nominal Wage Rigidity;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F44 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Business Cycles
    • H50 - Public Economics - - National Government Expenditures and Related Policies - - - General

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