International Dimensions of Fiscal Policy Transmission ∗

This paper analyzes the transmission of fiscal policy shocks in economies at different degrees of integration into global goods markets. First, using a quantitative business cycle model, we show that trade integration (measured by openness) does not alter the effects of government spending on output, but mutes the negative impact of government spending shocks on private demand. In fact, for very open economies, the model predicts a positive response of consumption to public spending shocks, even though we assume Ricardian behavior. Second, we provide supporting evidence using panel data for 19 OECD countries: consistent with our model, crowding-out effects on consumption and investment are found to be decreasing in a country’s openness to trade. A relevant implication is that more open economies are more likely to experience twin deficits.