Chapter 2 . Fiscal Policy , the Variety Effect , and the Real Exchange Rate ∗

This paper explores the effects of government consumption spending in a small open economy both under flexible and fixed exchange rate regimes. Varying price elasticity and the variety effect due to firm entry, are introduced to match the empirical evidences on the small open economy. The main mechanism is that firm entry leads to a higher price elasticity (hence variable markup), and increasing returns to specialization (or the variety effect). For the flexible exchange rate regime, I adopt varying price elasticity and the variety effect to resolve the puzzling empirical evidence: consumption crowding in and a positive co-movement between private consumption and the real exchange rate in response to a government spending shock. For the fixed exchange rate regime, I develop two types of models to replicate heterogeneous country dynamics (as in Chapter 1) in response to an increase in government spending. By properly combining the rule-of-thumb consumers and the variety effect (including varying price elasticity) assumptions, I construct two distinct models. For one model, I employ the variety effect as its main dynamics, for the other, the rule-of-thumb consumers. The main result from three models is that in terms of the stimulus effect, the models under the fixed exchange rate regime represent equivalent or inferior policy effect compared to the variety effect model under the flexible exchange rate regime. This result is different from the conventional wisdom. Another featuring result is that three models display somewhat different ordering in terms of the welfare implication, when compared to the ordering in terms of the stimulus effect.