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CEP discussion paper
On the International Dimension of Fiscal Policy
Gianluca Benigno and Bianca De Paoli
January 2009
Paper No' CEPDP0905:
Full Paper (pdf)

JEL Classification: E62; E63; F41

Tags: optimal policy; fiscal policy; small open economy

This paper analyses the international dimension of fiscal policy using a small open economy framework in which the government finances its spending by levying distortionary taxation and issuing non-state-contingent debt. The main finding of the paper is that, once the open economy aspect of the policy problem is considered, it is not optimal to smooth taxes following idiosyncratic shocks. Even when prices are flexible and inflation can costlessly act as a shock absorber to restore fiscal equilibrium, the presence of a terms of trade externality lead to movements in the tax rate. Also in contrast with the closed economy, the introduction of sticky prices can reduce the optimal volatility of taxes.