Government Spending During Sudden Stop Crises

Abstract

This paper studies the effect of government spending policy during sudden stop crises. Using a quarterly dataset of 30 small open economies, I find that government spending is more effective in stimulating consumption and appreciating the real exchange rate during sudden stops than during normal times. To rationalize this, I build a two-sector model with a collateral constraint on external debt. During a recession, an adverse international shock reduces consumption and undermines the value of collateral. The collapsing asset price in turn tightens the financial constraint, deteriorates the real absorption, and sets-in a fully-blown debt-deflation mechanism. In this context, an increase in government purchases exerts a counteracting force by raising asset prices and stimulating real activities. More importantly, if the government can commit to certain paths of spending in the future, the expected real appreciation will further relax the financial constraint today. I use a calibrated model to explore the multiplier effect under different exchange rate regimes, the asymmetric multipliers, and the multipliers under different levels of shock persistence.