Fiscal policy in classical and Keynesian open economies

The authors analyze the impact of fiscal policy changes in openeconomies, using a rational expectation framework that nests two prototype economies: a neoclassical full-employment benchmark economy, with intertemporally optimizing consumers and firms and instant clearing of asset, goods, and factor markets; and a Keynesian economy, with liquidity constraints and wage rigidity, which results in transitory deviations from full employment. The model is forward-looking in that the economy's short-run equilibrium depends on current and anticipated future values of all exogenous variables, and displays hysteresis (that is, its long-run equilibrium is path-dependent). Using parameters for a representative open economy, the model is simulated to compare the dynamic effects of increases in public spending financed by taxation, debt, and money. The results illustrate four points. Both permanent and transitory disturbances cause changes in long-run output and capacity. Transitory and permanent shocks may have opposite effects on the current account. Liquidity constraints and wage rigidities tend to amplify the cyclical adjustment to fiscal policy changes. The Keynesian economy's response to fiscal shocks depends critically on the way the budget is financed: money-financed fiscal expansion causes real depreciation; non-money-financed fiscal expansion causes appreciation.