The valuation of economic recovery: The case for investment-led fiscal spending policies in open economies

Abstract

We show quantitatively that an expansionary fiscal policy that takes into account future debt can be a valid tool to stabilize open economies subject to rare but severe shocks in a context of flexible exchange rates and capital flows. We assume that fiscal spending is directed towards investment to boost private spending, and that neoclassical preferences are replaced by preferences in which households also value economic recovery after a severe shock (preferences based on learning experience). Taken together, these seemingly unrelated conditions allow expansionary fiscal policy to induce a genuine recovery in the economy and to outperform some cases of expansionary monetary policy in terms of welfare. The mechanism is simple: investment-oriented fiscal spending, which ensures a faster recovery, is valued by households and thus stimulates consumption in a virtuous circle. Thus, a faster recovery based on investment-oriented fiscal spending is preferable to targets such as inflation and/or debt, which can still be maintained, but to preserve long-term stability.