The Effects of Fiscal Policy in a Small Open Economy with a Fixed Exchange Rate: The Case of Denmark

Working paper no 80, 2012

Authors Ravn, Søren Hove; Spange, Morten
Subject Danish Economy; Public finances and fiscal policy; Other economic analyses
Type Working paper
Year 2012
Published 4 September 2012
We study the empirical effects of fiscal policy in Denmark since the adoption of a fixed exchange rate policy in 1982. We demonstrate that fiscal stimulus has a rather large impact on economic activity in the very short run, with a government spending multiplier of 1.3 on impact in our preferred specification. Denmark's fixed exchange rate implies that the nominal interest rate remains fixed after a fiscal expansion, facilitating a substantial impact of the fiscal stimulus on the real economy. On the other hand, the large degree of openness of the Danish economy means that a sizeable share of the fiscal stimulus will be directed towards imported goods. Our results suggest that the 'monetary accommodation channel' dominates the 'leakage effect'. We also find that the effects of fiscal stimulus are very short-lived in Denmark, with the effect on output becoming insignificant after around a year. The fiscal multiplier is above 1 only in the first quarter, and drops to 0.6 one year after the shock. We further demonstrate that the fiscal multiplier is far from constant over time. While the multiplier was below 1 in the 1970's and 1980's, it has been above 1 in the 1990's and the 2000's, when Denmark has had a credibly fixed exchange rate and sound public finances.