Question

Consider the DD-AA small open economy model a. Assume imperfect asset substitutability. The interest parity condition now equalizes the domestic return to the foreign return plus the expected dollar depreciation and a risk premium. Suppose there is a permanent rise in domestic government spending, what is the impact of this on output?

Answer 1

It is shown that, for a given time path of government spending, a budget deficit raises world rates of interest and domestic wealth while it lowers foreign wealth. Thus, the deficit is transmitted negatively to the rest of the world. The channel of transmission is the world capital market and the negative transmission results from the higher rate of interest. The paper proceeds with an analysis of balanced budget changes in government spending. It is shown that a transitory current rise in government spending raises interest rates and lowers domestic and foreign wealth while an expected future rise in government spending lowers interest rates, reduces the value of domestic wealth and raises the value of foreign wealth. The effect of a permanent rise in government spending on the rate of interest depends on whether the domestic eonoray is a net saver or dissaver iii the world economy, i.e., if it has a current account surplus or deficit. If the home country runs a current account surplus then a rise in government spending raises world interest rates and lowers domestic and foreign wealth, and if the home country runs a current account deficit then a permanent balanced—budget rise in government spending lowers interest rates and domestic wealth and raises foreign wealth

In the international context this perspective implies that world rates of interest and other real variables depend only on total government spending rather than on the time path of the deficit. we have analysed the effects of fiscal spending on real rates of interest, debt and their international transmission

If the home country runs a current account surplus then a rise in government spending raises world interest rates and lowers domestic and foreign wealth, and if the home country runs a current account deficit then a permanent balanced-budget rise in government spending lowers interest rates and domestic wealth .

As a result, a search was done by linking government expenditure and the variables that can be determinants of government expenditure such as economic growth, government revenue, trade openness, poverty, public debt, dependency ratio, population, and urbanisation.