Ramsey Policies in a Small Open Economy with Sticky Prices and Capital

Abstract

This paper analyzes jointly optimal fiscal and monetary policies in a small open economy with capital and sticky prices. We allow for trade in consumption goods under perfect international risk sharing. We consider balanced-budget fiscal policies where authorities use distortionary taxes on labor and capital together with monetary policy using the nominal interest rate. First, as long as a symmetric equilibrium is considered, the steady state in an open economy is isomorphic to that of a closed economy. Second, whereas sticky prices allocations are almost indistinguishable from flexible prices allocations, the open economy dimension delivers results that are qualitatively similar to those of a closed economy but with significant quantitative changes. Fluctuations in terms of trade implied by complete international financial markets affect (i) consumption through changes in the consumption price index (CPI), (ii) hours through changes in the CPI-based real wage and (iii) capital accumulation through the relative price of capital goods. These wedges affect the volatility and persistence of optimal tax rates, and resulting allocations are quite different, as compared to a closed economy.

Keywords: small open economy, sticky prices, optimal monetary and fiscal policies

JEL Classification: E52, E53, E63, F41