Description

Despite the voluminous literature on fiscal policy, very few papers focus on low-income
 countries (LICs). This paper develops a new-Keynesian small open economy model to show,
 analytically and through simulations, that some of the prevalent features of LICs—different
 types of financing including aid, the marginal efficiency of public investment, and the degree of
 home bias—play a key role in determining the effects of fiscal policy and related multipliers in
 these countries. External financing like aid increases the resource envelope of the economy,
 mitigating the private sector crowding out effects of government spending and pushing up the
 output multiplier. The same external financing, however, tends to appreciate the real exchange
 rate and as a result, traded output can respond quite negatively, reducing the overall output
 multiplier. Although capital scarcity implies high returns to public capital in LICs, declines in
 public investment efficiency can substantially dampen the output multiplier. Since LICs often
 import substantial amounts of goods, public investment may not be as effective in stimulating
 domestic production in the short run.

More publications in this series: Working Papers

More publications by: Wenyi Shen ; Susan S. Yang ; Luis-Felipe Zanna