Three essays on the effects of government spending in a small open economy

Although fiscal policy analysis has a long history, the analysis of the effects of government spending in a small open economy has not been satisfactorily conducted either theoretically or empirically. In the next three chapters I develop theoretical models and empirical evidence for small open economies. In the empirical chapter, I explore the effects of government spending in the Euro area, where fixed exchange rate regimes have been maintained. I employ Bayesian pooling methods to investigate whether there is heterogeneity in country dynamics. Two-subgroup pooling suggests that there are heterogeneous transmission mechanisms across groups of countries in response to government spending shocks. The theoretical models apply to both flexible and fixed exchange rate regimes. To resolve the puzzling co-movement of private consumption and the real exchange rate in flexible exchange rate regimes, I examine the roles of firm entry and variety effects that lead to varying price elasticity and increasing returns to specialization. I construct two models for fixed exchange rate regimes to replicate the heterogeneous dynamics that are discussed in the empirical chapter: I introduce rule-of-thumb consumers into one model; I employ firm entry and the variety effect in the other model. The three models represent that government spending in fixed exchange rate regimes has equivalent or smaller stimulating effects on GDP in comparison with that in a flexible exchange rate regime. Openness and trade elasticity generate diverse movements of macroeconomic variables that depend on both exchange rate regimes and theoretical models. In the last chapter, I bring the theory together with the empirical evidence by matching impulse response functions from the data and the theoretical model. The estimation results confirm that there are heterogeneous dynamics across groups of countries.