Hostname: page-component-669899f699-swprf Total loading time: 0 Render date: 2025-04-25T01:14:14.217Z Has data issue: false hasContentIssue false

Optimal fiscal policy in small open economies with habit persistence

Published online by Cambridge University Press:  23 September 2024

Yongseung Jung*
Affiliation:
Department of Economics, Kyung Hee University, Seoul, Republic of Korea

Abstract

This paper sets up a small open economy model with habit persistence in consumption in which distortionary taxation is available in a flexible price environment. In open economy, the habit persistence in consumption aggravates the terms of trade externality, absent in closed economy, calling for more aggressive fiscal policy. While optimal labor income taxes are time-invariant in a closed economy with internal habit, they should be time-varying in an open economy to alleviate the terms of trade externality, even if the intertemporal elasticity of substitution equals the intratemporal elasticity of substitution. In a small open economy composed of households with habit persistence in consumption, households’ decision to gradually adjust their consumption and labor hours intensifies the undesirable terms of trade externality or the terms of trade channel. This generates a time-varying wedge between the efficiency conditions of the Ramsey planner and the market equilibrium conditions, calling for a time-varying taxation which takes into account the intertemporal elasticity of substitution and the intratemporal elasticity of substitution between home and foreign goods, in addition to the degree of habit and goods market distortion. The volatility of optimal tax rate increases with the degree of habit, whether households have external or internal habit. The volatility of tax rate shows an inverted U-shape in the degree of openness in the small open economy with habit. Finally, the optimal labor income tax rate moves countercyclically for low degree of intratemporal elasticity of substitution, while it moves procyclically for high degree of intratemporal elasticity of substitution.

Type
Articles
Copyright
© The Author(s), 2024. Published by Cambridge University Press

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Article purchase

Temporarily unavailable

References

Abel, A. B. (1990) Asset prices under habit formation and catching up with the joneses. American Economic review Papers and Proceedings 80, 3842.Google Scholar
Abel, A. B. (1999) Risk premia and term premia in general equilibrium. Journal of Monetary Economics 43(1), 333.CrossRefGoogle Scholar
Adolfson, M., Laséen, S., Lindé, J. and Villani, M.. (2007) Bayesian estimation of an open economy DSGE model with incomplete pass-through. Journal of International Economics 72(2), 481511.CrossRefGoogle Scholar
Auray, S., de Blas, B. and Eyquem, A.. (2011) Ramsey policies in a small open economy with sticky prices and capital. Journal of Economic Dynamics and Control 35(9), 15311546.CrossRefGoogle Scholar
Auray, S., Eyquem, A. and Gomme, P.. (2018) Ramsey-optimal tax reforms and real exchange rate dynamics. Journal of International Economics 115, 159169.CrossRefGoogle Scholar
Benigno, G. and De Paoli, B.. (2010) On the international dimension of fiscal policy. Journal of Money, Credit and Banking 42(8), 15231542.CrossRefGoogle Scholar
Benigno, P. and Woodford, M.. (2003) Optimal monetary and fiscal policy: A linear- quadratic approach. In: Benigno, P. and Woodford, M.. (eds.), NBER Macroeconomics Annual 2003, vol. 18, 271364. Cambridge, MA: National Bureau of Economic Research.Google Scholar
Bohn, H. (1990) Tax smoothing with financial instruments. American Economic Review 80, 1279–1230.Google Scholar
Chari, V. V., Christiano, L. J. and Kehoe, P. J.. (1991) Optimal fiscal and monetary policy: some recent results. Journal of Money, Credit and Banking 23(3), 519539.CrossRefGoogle Scholar
Chen, S., Devereux, M. B., Shi, K. and Xu, J.. (2021) Exchange rates, local currency pricing and international tax policies. Journal of Monetary Economics 117, 460472.CrossRefGoogle Scholar
Christiano, L. J., Eichenbaum, M. S. and Evans, C. L.. (2005) Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 115(1), 145.CrossRefGoogle Scholar
Christiano, L. J., Trabandt, M. and Walentin, K.. (2007) Introducing financial frictions and unemployment into a small open economy model. Sveriges Riksbank Working Paper 214.Google Scholar
Corsetti, G., Dedola, L. and Leduc, S.. (2010) Optimal Monetary Policy in Open Economies. In: Corsetti, G., Dedola, L. and Leduc, S.. (eds.), Handbook on Monetary Economics, pp. 861933. Amsterdam; New York and Oxford: Elsevier Science, North-Holland.Google Scholar
De Paoli, B. (2009) Monetary policy and welfare in a small open economy. Journal of International Economics 77, 1122.CrossRefGoogle Scholar
Ester, F. and Monacelli, T.. (2008) Optimal monetary policy in a small open economy with home bias. Journal of Money, Credit and Banking 40(4), 721750.Google Scholar
Farhi, E., Gopinath, G. and Itskhoki, O.. (2014) Fiscal devaluations. Review of Economic Studies 72(3), 707734.Google Scholar
Galí, J. and Monacelli, T.. (2005) Monetary policy and exchange rate volatility in a small open economy. Review of Economic Studies 72(3), 707734.CrossRefGoogle Scholar
Hjortsø, I. (2016) Imbalances and fiscal policy in a union. Journal of International Economics 102, 225241.CrossRefGoogle Scholar
Jung, Y. (2015) Price stability in economies with habit persistence. Journal of Money, Credit and Banking 47(4), 517549.CrossRefGoogle Scholar
Ljungqvist, L. and Harold, U.. (2000) Tax policy and aggregate demand management under catching up with the joneses. American Economic Review 90(3), 356366.CrossRefGoogle Scholar
Lucas, R. E. Jr and N. Stokey. (1983) Optimal fiscal and monetary policy in an economy without capital. Journal of Monetary Economics 12, 5593.CrossRefGoogle Scholar
Schmitt-Grohe, S. and Uribe, M. (2007) Optimal inflation stabilization in a medium-Scale Macroeconomic Model. In: Gertler, M. and Rogoff, K. (eds.), NBER Macroeconomics Annual 2005, 383–425. Cambridge MA: MIT Press, 2006.Google Scholar
Schmitt-Grohé, S. and Uribe, M.. (2004) Optimal fiscal and monetary policy under sticky prices. Journal of Economic Theory 114(2), 198230.CrossRefGoogle Scholar
Smets, F. and Wouters, R.. (2007) Sources of business cycle fluctuation in the U.S.: A Bayesian DSGE approach. American Economic Review 97(3), 586606.CrossRefGoogle Scholar
Tang, J.-H. (2020) Ramsey income taxation in a small open economy with trade in capital goods. The B.E. Journal of Macroeconomics 20(1).CrossRefGoogle Scholar
Woodford, M. (2003) Interest and prices: Foundations of a theory of monetary policy. Princeton, NJ: Princeton University Press.CrossRefGoogle Scholar