Trade Frictions and the Small Open-Economy Fiscal Multiplier

This paper shows that, once households hold intertemporal marginal propensities to consume out of income which are consistent with micro evidence, sectoral and trade frictions become central for the output response to a government spending shock in a small open economy. This result holds for both fixed and flexible exchange rate regimes, with the four-year cumulative multiplier out of a transitory spending shock reaching 1.5 and 1.4, respectively. The dampening effect of the frictions on international trade, a key determinant of the output response in highly open economies, explains why those multipliers are larger than the simple one-sector economy counterpart. Absent of the consumption impulse inherent to our heterogeneous-agent economy, trade frictions matter much less for fiscal multipliers.