Adaptive Importance Sampling Estimation of an Open Economy Model with Fiscal Policy

We propose and estimate an open economy general equilibrium model that includes international trade between Canada and the US. For both countries, we consider a rich fiscal policy sector with two different types of public expenditure: productive and unproductive government spending. We estimate our model using a new adaptive methodology based on the Mixture of Student's t by Importance Sampling weighted Expectation-Maximization (MitISEM). Our findings regarding the Canadian economy indicate that, irrespective of the type of government expenditure, an increase in domestic public spending leads to an improvement of the domestic trade balance. Notably, we find that the domestic real exchange rate appreciates in response to a positive shock in the domestic unproductive government expenditure, whereas it depreciates after an increase in the domestic productive government spending. Our analysis indicates that a decrease in trade openness, for example resulting from a possible trade war, has important consequences for the propagation of productive and productive government spending shocks on the economy.