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Monetary policy in a small open economy with non-separable government spending

Haytem Troug (International Monetary Fund, Washington, District of Columbia, USA)
Ernil Sabaj (Department of Economics, University of Warwick, Coventry, UK)

Journal of Economic Studies

ISSN: 0144-3585

Article publication date: 19 October 2023

Issue publication date: 2 January 2024

64

Abstract

Purpose

Despite being a flexible tool that can address several macroeconomic issues, Dynamic Stochastic General Equilibrium (DSGE) models have been rarely used to analyse the interaction between monetary and fiscal policy until the post-financial crisis, leaving a gap in the analysis of how government consumption affects the transmission mechanism of monetary policy. This motivates this paper to analyse how government consumption affects the dynamics of a small open economy, once the former is included in a non-separable form to the utility function. To the best of the authors' knowledge, this issue has not been addressed by the literature, and the authors aim to do so in this paper.

Design/methodology/approach

A standard New Keynesian model for a small open economy is used to allow for the presence of non-separable government consumption in the utility function. The model is supported by panel regressions.

Findings

The inclusion of Government consumption dampens the transmission mechanism of monetary policy. The degree of openness dampens the crowding out effect of fiscal policy to monetary policy, as the exchange rate channel empowers it. Empirical estimates for 35 OECD countries support the theoretical findings of the model.

Originality/value

The effect of government consumption on the transmission mechanism of MP has not been addressed in the literature. This paper contributes to the literature by addressing this issue.

Highlights:

  • • The inclusion of Government consumption dampens the transmission mechanism of monetary policy.

  • • The degree of openness alleviates the crowding out effect of fiscal policy to monetary policy, as the exchange rate channel empowers it.

  • • Empirical estimates for 35 OECD countries support the theoretical findings of the model.

Keywords

Acknowledgements

The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF, its Executive Board and IMF management.

Citation

Troug, H. and Sabaj, E. (2024), "Monetary policy in a small open economy with non-separable government spending", Journal of Economic Studies, Vol. 51 No. 1, pp. 39-70. https://doi.org/10.1108/JES-10-2022-0513

Publisher

:

Emerald Publishing Limited

Copyright © 2023, Emerald Publishing Limited

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