Liquidity constraints and tax policy in small open economies
State-contingent tax policy can generate stabilization gains if an economy is subjectto occasionally binding financial constraints. The aim of this paper is to assesswhether that claim can be supported in a small open economy real business cyclemodel with liquidity constraints on the consumer side. In the model, the domesticcurrent account deficit is limited by domestic output such that the ability of consumersto self-insure against productivity risks is restricted. The model is calibratedto Argentine data and solved with standard perturbation methods, using a penaltyfunction approach to account for the non-linear current account restriction. The resultsshow that the presence of liquidity constraints leads to volatile and procyclicalconsumption spending consistent with the data. In this environment, a governmentcan provide some of the missing insurance to consumers by cutting tax rates onlabor income in low-productivity states and vice versa. This type of policy raisesdomestic liquidity through higher output when necessary, which eases the currentaccount restriction and smoothens out consumption.Keywords: Small open economy models; Real business cycles; Financial frictions;Liquidity constraints; Limited self-insurance; State-contingent tax policy
Year of publication: |
2009
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Authors: | Kirchner, M. |
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