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Paper No' CEPDP0905: | Full paper
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Keywords: optimal policy; fiscal policy, small open economy
JEL Classification: E62; E63; F41
Is hard copy/paper copy available? YES - Paper Copy Still In Print.
This Paper is published under the following series: CEP Discussion Papers
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Abstract: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.
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