Fiscal Policy in a Floating Exchange Rate Regime with Consumption Home Bias

Abstract

This paper presents New Open Economy Macroeconomics as the analytical framework in attempt to explore the long term effects of fiscal expenditure shocks on various macroeconomic variables (e.g. consumption, output, prices, exchange rate, terms of trade), and tries to explain the role that consumption home bias plays. With theoretical derivation and simulation analysis, we find that in the long-term, an increasing in fiscal spending will cause rise of domestic output, domestic price index and the exchange rate, but it will crowd out domestic private consumption, the relationship between fiscal spending and the terms of trade, which is depending on asymmetry of consumption bias behavior of consumers between countries.