Borrow and Adjust. Fiscal Policy and Sectoral Adjustment in an Open Economy.

Should the government run fiscal deficits in response to an adverse external shock that reduces national income permanently, warranting transfer of resources from production of non-traded to traded goods? This paper considers fiscal policy implications of sectoral adjustment costs in a model with non-Ricardian concumers. We show that even in the absence of nominal rigidities, temporary fiscal deficits increase social welfare if sectoral adjustment costs prevent immediate adjustment. If there are no adjustment costs, the case for fiscal deficits vanishes.