By Ali Alichi, Ippei Shibata and Kadir Tanyeri
Government debt in many small states has risen beyond sustainable levels and some governments are considering fiscal consolidation. This paper estimates fiscal policy multipliers for small states using two distinct models: an empirical forecast error model with data from 23 small states across the world; and a Dynamic Stochastic General Equilibrium (DSGE) model calibrated to a hypothetical small state’s economy. The results suggest that fiscal policy using government current primary spending is ineffective, but using government investment is very potent in small states in affecting the level of their GDP over the medium term. These results are robust to different model specifications and characteristics of small states. Inability to affect GDP using current primary spending could be frustrating for policymakers when an expansionary policy is needed, but encouraging at the current juncture when many governments are considering fiscal consolidation. For the short term, however, multipliers for government current primary spending are larger and affected by imports as share of GDP, level of government debt, and position of the economy in the business cycle, among other factors.
Rarely is the (fixed) exogenous assumption of the small country model more applicable than in this paper looking micro-states. Yet, I sense from the results (comparing debt and interest on debt) that the interest rate is not constant in this model. I wonder how this is motivated in the IMF’s DSGE model. Also, speaking of fiscal policy in micro-states, clearly they are also driven by fiscal haven considerations, i.e., a game with the rest of the world trying to attract mobile income and wealth. I do not think the model captures this either, and I am not expecting it to do so, but this seems to be an important consideration for this particular application.