“Fiscal Consolidation in a Small Open Economy with Sovereign Risk”

Zixi Liu, Goethe University Frankfurt

A non-standard monetary policy is introduced to model sovereign risk following the 2009 European debt crisis. I develop a DSGE model in a small open economy with sovereign risk to contribute to the debate on whether fiscal consolidation could be expansionary. I assume that fiscal consolidation is either government spending-based or tax-based, which is introduced through a negative government spending shock, a positive labor income tax policy shock and a positive domestic bond returns tax shock respectively. The conclusion shows that fiscal consolidation cannot be expansionary in a small open economy with sovereign risk based on the model setup. A non-Keynesian effect with an increase in aggregate demand shows up after a spending-based consolidation. Besides, a positive technology shock can stimulate the economy but at the same time, it increases both government debt-GDP ratio and foreign debt-GDP ratio. The policy makers thus have to implement a well-designed fiscal austerity program with technology improvement to reduce government debt-GDP ratio and stimulate the economy in the meanwhile.