Optimal government spending in a collateral-constrained small open economy

This paper characterizes optimal government spending and evaluates simple fiscal rules in a collateral-constrained small open economy in which borrowing decisions are distorted by a pecuniary externality. Optimal fiscal policy intervenes both ex ante, by mitigating overborrowing when the borrowing constraint is slack, and ex post, by supporting collateral values when the constraint binds. The ex post intervention plays a more important stabilization role. By supporting collateral values, fiscal expansion during constrained periods dampens the debt-deflation mechanism and limits sharp current-account reversals. Optimized feedback rules and an implementable rule that maintains a constant government-spending-to-GDP ratio also generate fiscal expansion during financial crises. By contrast, the estimated procyclical GDP-feedback rule generates fiscal contraction during crises and entails a substantial welfare cost. The constant-ratio rule delivers higher welfare than the optimized GDP-feedback rule while requiring less information to implement. The welfare gain from capital controls is generally smaller when fiscal policy already provides ex post support.