The transitional dynamics of fiscal policy in small open economies

We study the dynamic macroeconomic effects of fiscal shocks under lump-sum tax financing. To this end, we develop an intertemporal macroeconomic model for a small open economy, featuring monopolistic competition in the intermediate goods market, endogenous (intertemporal) labor supply, and finitely lived households. Fiscal shocks are shown to yield endogenously determined (dampened) cycles for a realistic calibration of the model. Impulse response functions of fiscal policy shocks in the finite-horizon model differ substantially from those resulting from an infinitely lived representative agent model. This can be explained by the presence of Ethier-productivity effects, which increase the size of long-run output multipliers to a greater extent in the infinite-horizon model.