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In this paper, we develop a general model of an imperfectly competitive small open economy. There is a traded and non-traded sector, whose outputs are combined in order to produce a single final good that can be either consumed or invested. We make general assumptions about preferences and technology, and analyze the impact of fiscal policy on the economy. We find that the fiscal multiplier is between zero and one, and provide sufficient conditions for it to be increasing in the degree of imperfect competition. We also are able to compare the multiplier under free-entry and with a fixed number of firms and welfare. A simple graphical representation of the model is developed.

This paper focuses on the relationship between markups, profits and entry in an open economy. There is now a well established literature which explores the effects of imperfect competition in output markets on fiscal policy in a closed economy.1 With perfectly competitive labor markets, the key result is that the presence of imperfect competition in the product market leads to a profit multiplier, by which an initial increase in output generates a positive feed-back onto consumption via profits which is stronger with larger markups. As Startz (1989) argued, this effect will be absent when free-entry drives profits down to zero or in a Walrasian model with constant returns when profits are zero anyway. This paper seeks to extend this analysis to a dynamic small open economy model, developing the Walrasian framework of Turnovsky et al. 2 by explicitly introducing monopolistic competition and entry into the model. We keep the traditional Ramsey assumption of a single final output which can be used for consumption, investment or government expenditure, with the traded and non-traded goods as intermediates. There are two factors or production (capital and labor). The Ramsey household holds two assets, capital and an international bond and solves the standard intertemporal optimization problem giving rise to the dynamics of the economy. The main innovation in the paper is the inclusion of monopolistic competition in the output market: we retain perfect competition in the labor market.3 We are able to provide a simple graphical analysis of the steady-state effects of fiscal policy and consider the relationship between the multiplier and the markup. We are able to show that whenever there is imperfect competition, the multiplier is larger when there is a fixed number of firms as opposed to the free-entry case. The multiplier is increasing in the degree of imperfect competition when preferences and technology are Cobb–Douglas. Throughout, the profit effect of imperfect competition without free-entry is vital for understanding the multiplier and resultant welfare effects. A crucial feature in the dynamic case is that we need to consider changes in the net present value of profits: in particular we find that variations in profit along the path to equilibrium influence the steady-state equilibrium through their impact on household wealth. Our setup differs in certain key respects from other papers. We allow for a general non-separable utility function over consumption and leisure (in many papers, either there is no disutility of work—e.g. Dornbusch, 1983; Turnovsky, 1991; or it is additive—e.g. Sen and Turnovsky, 1991). Whilst it is standard in RBC models to have leisure in utility, it usually takes specific functional forms (e.g. Backus et al., 1995). We also specify technology in terms of homothetic functions: this enables us to understand which results are due to specific forms (Cobb–Douglas or CES) and which are more general. The paper is organized as follows. Section 2 describes the disaggregated microlevel in the final output market, the two intermediate sectors and the factor markets, where the relationships are primarily intratemporal. In Section 3 we analyze the aggregate level with a representative Ramsey consumer which captures the intertemporal relationships and the portfolio behavior which yields the dynamic equilibrium of the economy. The steady state and dynamic properties of the equilibrium are described in Section 4 and given graphical expression. The impact of imperfect competition on th

In this paper, we have attempted to develop a general yet tractable framework with which to analyse the conduct of fiscal policy in the context of a small open economy with an imperfectly competitive non-traded sector. The approach does not rely on special assumptions about the functional forms of preferences or technology, yet is able to yield some clear results. In addition, we have developed a diagrammatic approach to the analysis of fiscal policy to complement the mathematical analysis. This general approach can be developed. For some applications, it might be desirable to have imperfect competition in the traded sector in addition to or instead of the non-traded sector. The existing modelling framework can also be extended by introducing other features: distortionary taxes and tariffs, Ethier and other productivity effects, public infrastructure effects and different types of imperfect competition.