Optimal Fiscal Policy and Amplification in a Small Open Economy∗

We study optimal fiscal policy in a small open economy characterized by two main frictions – incomplete financial markets and an inability of the government to commit to policy. Our main contribution is to show that in this environment, the best sustainable policy can amplify and prolong shocks to output. In particular, the government’s credibility not to expropriate foreign capital endogenously varies with the state of the economy and may be “scarcest” during recessions. This increased threat of expropriation depresses investment and prolongs downturns. ∗We thank comments and suggestions from Andy Atkeson, Doireann Fitzgerald, Pierre-Olivier Gourinchas, Hugo Hoppenhayn, Pat Kehoe, Narayana Kocherlakota, Enrique Mendoza, Marcelo Oviedo, Chris Phelan, Ken Rogoff, Paul Romer, Andy Rose, Aleh Tsyvinsky, Carlos Vegh and Ivan Werning. We also thank seminar participants at Berkeley, Board of Governors, Cornell, Harvard, NBER summer institute, SED, Minneapolis Fed, New York University, Boston University, New York Federal Reserve Bank, Northwestern University and University of California at Santa Cruz for comments.