Essays on optimal fiscal policy and international business cycles

This dissertation consists of three essays. The first essay studies optimal fiscal policy in a small open economy where interest rates, government spending and productivity are stochastic, taxes are distortionary and markets are incomplete. In particular, I analyze how the structure of international financial markets and shocks to the interest rate, productivity and government spending affect the properties of optimal fiscal policy using a stochastic dynamic general equilibrium model of a small open economy. The main contributions of this essay are the following. First, I solve the Ramsey problem and characterize the optimal fiscal policy in this environment. Second, I provide a new framework to analyze optimal fiscal policy in small open emerging economies.The second essay characterizes the behavior of debt and tax rates in a small open economy under both complete and incomplete markets using Ramsey's approach to optimal taxation, and compares the predictions of these models with the behavior of Mexican public debt. The contributions of the paper are twofold. First, I show that when the agents have access to international complete asset markets, debt inherits the serial correlation structure of the shocks. Moreover, government debt decreases in response to positive government spending shocks, and increases in response to positive productivity shocks. By contrast, if financial markets are incomplete in the open economy, government debt increases in response to positive government spending shocks, decreases in response to positive productivity shocks, and shows more persistence than the shock processes irrespective of the degree of autocorrelation of the underlying shocks. Second, I show that the behavior of Mexican government debt is more consistent with the incomplete markets model than with complete markets model.The third essay introduces a distribution sector into the standard two-sector, two-country real business cycle model. Firms in the distribution sector combine intermediate tradable goods with non-traded distribution services to produce a final consumption good. I found that the model is successful in replicating the low cross-country correlations of consumption of tradable goods, however, its main failing is that it produces cross-country correlations of output that are smaller than those observed in the data.