Fiscal policy in a small open economy

The great recession of 2008-2009 has brought fiscal policy modelling and analysis to the forefront, motivating a deeper understanding of fiscal issues. This thesis develops various strands of fiscal policy literature focusing on the identification of fiscal shocks, the modelling fiscal rules and the welfare implications of fiscal policy. The first few chapters are dedicated to building a rich fiscal model with debt rules for Canada and the last chapter explores the welfare implications of these fiscal rules. In the second chapter, we explore the role of temporary government spending shocks on macroeconomic fluctuations, primarily focusing on the response of private consumption. We estimate a four variable structural Vector Auto-Regression (VAR) model. We find across various identification approaches, a positive unanticipated temporary government spending shock generates a negative response in private consumption and a positive response in output. In the third chapter, we build a Dynamic Stochastic General Equilibrium (DSGE) model to account for these empirical findings. We use Bayesian estimation techniques to estimate five debt rules that correspond to various policy instruments and report the elasticities of these instruments to the cycle and the stock of federal government debt in Canada. We find an elasticity in response to debt of 0.26 for government spending and 0.16 for transfer payments. We find insignificant elasticities for the response of average effective tax rates to debt. Our findings support the presence of strong automatic stabilizers in Canada, with an elasticity of 0.41 and 1.73 for the response of average labour and capital tax rates to the cycle. In chapter four, we extend the homogenous framework in chapter three to a heterogeneous agent setting by introducing liquidity constrained agents and analyze the welfare effects of balanced budget rules and debt rules. Our results show that debt rules improve aggregate welfare in the economy compared to a balanced budget rule. This result is driven by the welfare gains of a large share of Ricardian households. The remaining liquidity-constrained households experience a welfare loss under debt rules, indicating that a balanced budget rule is preferable for agents who cannot engage in inter-temporal consumption smoothing.