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Utility functions, fiscal shocks and the open economy - In the search of a positive consumption multiplier

Listed author(s):
  • Philipp Wegmueller

This paper analyzes the dynamic effects of a fiscal policy shock and its transmission mechanism in a small open economy and compares the responses under different specifications of the utility function. The traditional Mundell-Flemming model tells that fiscal policy is more effective under a peg than under a float. This result is not confirmed for a baseline small open economy model with separable preferences. The present paper offers a survey of non-separable utility found in the literature on fiscal policy shocks and compares their implications for the transmission mechanism. The aim is to overturn the negative wealth effect of an increase in government spending, which causes a decrease in private consumption under the baseline separable utility function. Using a plausible calibration of the model, I find that if the complementarity between consumption and hours worked is large enough, then the response of private consumption is likely to be positive, although the assumptions have to be strong. This result holds for any specification of exchange rate regime.

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File URL: http://www.vwl.unibe.ch/wp-content/uploads/papers/dp/dp1407.pdf
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Paper provided by Universitaet Bern, Departement Volkswirtschaft in its series Diskussionsschriften with number dp1407.

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Date of creation: Oct 2014
Handle: RePEc:ube:dpvwib:dp1407
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  1. Robert E. Hall, 2009. "By How Much Does GDP Rise If the Government Buys More Output?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 40(2 (Fall)), pages 183-249.
  2. Olivier Blanchard & Roberto Perotti, 2002. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," The Quarterly Journal of Economics, Oxford University Press, vol. 117(4), pages 1329-1368.
  3. King, Robert G. & Plosser, Charles I. & Rebelo, Sergio T., 1988. "Production, growth and business cycles : I. The basic neoclassical model," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 195-232.
  4. Linnemann, Ludger, 2006. "The Effect of Government Spending on Private Consumption: A Puzzle?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1715-1735, October.
  5. Ravn, Morten O. & Schmitt-Grohé, Stephanie & Uribe, Martín, 2012. "Consumption, government spending, and the real exchange rate," Journal of Monetary Economics, Elsevier, vol. 59(3), pages 215-234.
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