RIEB, Kobe University

An Optimal Government Spending Reversal Rule in a Small Open Economy

This paper presents a reexamination of debt stabilization policy in a small open economy borrowing from abroad. Spending reversals are incorporated as a policy option available to policy-makers for stabilizing public debt. Results show that a spending reversal rule can be welfare-improving and that there exists an optimal degree of spending reversal. An optimal spending reversal rule can lower both the tax rate volatility and interest rate volatility compared with the case without the reversal rule. Results also suggest that, as friction in foreign borrowing becomes greater (because of a higher country-specific interest rate premium), the welfare benefit of the reversal rule will be increasingly important.