Fiscal Multipliers: Lessons from the Great Recession for Small Open Economies

We assess empirical evidence and theoretical work on the determinants of the fiscal multiplier. Recent empirical literature suggests that short-run spending multipliers are larger under fixed exchange rate regimes, in economic downturns and during financial crises. However, the evidence on their magnitude under fiscal stress is mixed. Using a stylised model of a small open economy, we carry out a close-up analysis of the transmission of fiscal policy conditional on monetary/exchange rate regimes, policy rates at the zero lower bound, credit constraints and sovereign risk. We show that the size of shortrun multipliers crucially depends on the interaction of monetary and budget consolidation policies, especially when weak public finances expose the economy to sovereign risk crises.