In this paper a new Keynesian small open economy model with a strengthened focus on the fiscal sector is developed, to analyze the effects of fiscal policy. Compared with conventional new Keynesian models, the one developed in this paper has the following differences: First, it covers both optimizing and rule-of-thumb households ─ the latter being those that use up all their incomes earned each period, as they have no access to financial institutions and are unable to accumulate capital. Inclusion of these households in the model makes it possible to analyze the effects of government transfer payments. Second, government consumption, as well as private consumption, affects household utility, with the fiscal multiplier varying depending upon the complementarity between private and government consumption. Finally, the government operates its fiscal policy, as well as monetary policy, according to rules and regulations.
The model is estimated through a Bayesian method and has the following characteristics: First, unlike in conventional new Keynesian ones, in this new model it is seen that growth in government consumption leads to an increase in private consumption. This matches the results of empirical analyses, and results from the existence of rule-of-thumb households in the model and from the private-government consumption complementarity. Second, the government expenditure multiplier is estimated at 0.8 and the government transfer payment multiplier at below 0.8. It is analyzed that, if a closed economy is assumed or if the policy rate is kept at a certain level, the government expenditure multiplier is close to 1. Finally, fiscal rules show that the more the government expenditure responds to business conditions and the more flexible it is, the larger the government expenditure multiplier becomes.
Therefore, in order to carry out efficient fiscal policy operations, it is judged necessary to strengthen the automatic stabilizer, functions of the fiscal system and to increase government expenditure in areas having high complementarity with private expenditure.