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In this paper we introduce an overlapping generations structure of the Blanchard (J. Polit. Econ. 93 (1985) 121) type in a New Open Economy Macroeconomics (NOEM) model. This allows us to study a wider range of fiscal shocks compared to the traditional Mundell–Fleming (MF) and to the baseline Redux models. We show that a debt-financed tax cut appreciates the short-run exchange rate, but this result is reversed in the long run. A debt-financed increase of government spending, on the other hand, has ambiguous exchange rate effects. Our model also provides a bridge between the NOEM framework and the MF model.

The study of the international effects of fiscal policy shocks is a classical exercise in open economy macroeconomics, that dates back at least to the original development of the Mundell–Fleming (MF) model.1 Fiscal policy, however, has received comparatively less attention than monetary policy in recent theoretical research based on microfounded models. An obvious example of this unbalance can be found in the development of the New Open Economy Macroeconomics (NOEM) literature.2 The NOEM literature has to date concentrated on monetary issues, with the fiscal side receiving scant attention. The main reason why fiscal policy has been so far under-researched in this framework is that, with Ricardian Equivalence holding in the basic NOEM model, the analysis of fiscal issues was necessarily limited to balanced-budget policies.3 In the NOEM model presented in this paper, Ricardian Equivalence does not hold.4 This is an important difference from the earlier contributions, which allows us to enrich the original NOEM setup in order to study a menu of alternative fiscal policy actions. In particular, we can analyze the real effects of debt policies on the main macroeconomic variables in an open economy framework and compare them to the effects of balanced-budget policies. The possibility of considering alternative fiscal policy options means that our analysis can also give some insights on the consequences of different ways of financing a given level of government spending, by contrasting tax financing with debt financing. The latter is another important difference with the existing literature on fiscal policy, which usually focuses on changes in the level of government spending rather than on changes in the financing choices of a given amount of spending. The main channel at work in the model is the interaction between consumption, money demand and the price level. We show that, with finite horizons, a debt-financed tax cut generates a short-run increase in domestic consumption, which in turn increases the domestic money demand relative to the foreign. For a given money supply, and in the presence of complete pass-through of exchange rate fluctuations to prices, this determines an appreciation of the domestic nominal exchange rate in the short run. The fall in net foreign assets caused by this policy, however, implies that this result is reversed in the long run. The effect on the exchange rate depends on the temporal horizon, with the domestic currency actually depreciating in the long run. When the fiscal expansion is implemented through a balanced-budget increase in government spending, short-run private consumption is crowded out and the short-run exchange rate effect is a nominal depreciation of the domestic currency. These results have important implications for the study of the consequences of different financing choices of a given level of government spending, which we discuss in Section 3.5. Our model can also reconcile the old and the new paradigms for the analysis of fiscal policy interdependence with respect to the exchange rate and output spillover effects. In the original Redux framework, a fiscal shock depreciates the exchange rate and has a negative effect on foreign output. These results are opposite to the ones derived in the two-country version of the MF model. In our model, the expenditure switching effect, due to the short-run appreciation of the exchange rate, implies that the short-run positive output spillover of a debt-financed tax reduction is unambiguously positive. Introducing a finite time horizon therefore helps in reconciling the NOEM framework with the MF tradition, as we discuss in Section 3.4. The structure of the paper is the following: the next section introduces the model; Section 3 derives and discusses the macroeconomic effects of a debt-financed reduction in taxes; both the positive and the welfare implications are discussed. The debt effects are then compared to the effects of alternative fiscal actions, and are discussed in relation to the Redux and MF benchmarks. Section 4 concludes.

This paper combines the Obstfeld and Rogoff (1995) framework with an overlapping generations structure of the Blanchard (1985) type. In our model, a debt-financed reduction in taxation by the domestic country unambiguously raises relative consumption, appreciates the domestic exchange rate and reduces relative output in the short run. The reduction in net foreign assets triggered by this policy, however, implies that in the long run the exchange rate effect is reversed. In welfare terms, the Home country is likely to gain more than the Foreign country from a domestic tax cut, unless a very large weight is attached to the utility of the yet unborn generations. Our model also focuses on the implications of the different financing choices (taxes versus debt) of a given level of government spending. Furthermore, some of our short-run results represent a significant step forward in reconciling the old and the new paradigms for the analysis of fiscal policy interdependence. Since complete exchange rate pass-through plays an important role in our model, it is interesting to speculate how our results would change in an economic environment in which the degree of pass-through is only partial. On an intuitive basis, the increase in short-run consumption would not be affected by a lower degree of pass-through. A lower pass-through would, however, reduce the size of the expenditure switching effect, so the short-run increase in relative output would be likely to be mitigated. An extension of the model with lower (or zero) pass-through would allow us to analyze those effects rigorously. The latter is undoubtedly an important topic for future research. Another issue that warrants further investigation is the robustness of our results to changes in monetary policy assumptions. Several authors (for example, Benigno and Benigno, 2001 and Cavallo and Ghironi, 2002) have emphasized the importance of the endogenous reaction of monetary policy to macroeconomic dynamics. In this perspective, an extension of the setup presented in this paper in which interest rates are allowed to react to inflation and to other macroeconomic variables is a promising avenue to follow for future research. Similarly, an empirical test of the implications of our model would be of interest.