Optimal Government Spending in a Collateral-Constrained Small Open Economy

This paper characterizes the optimal government spending policy in a collateral- constrained small open economy, where inefficiencies in borrowing decisions arise due to pecuniary externalities. In this setting, government spending plays a crucial role in maintaining financial stability. When the borrowing constraint binds, the optimal response involves fiscal stimulus, which mitigates the effects of pecuniary externalities and prevents the amplification of the debt-deflation mechanism. The optimal time-consistent policy helps prevent recessionary shocks from triggering financial crises and sharp reversals in the current account. Additionally, when capital controls are optimally combined with government spending, households are incentivized to accumulate precautionary savings more effectively. The welfare gain from capital controls is smaller when government spending is optimally chosen. We demonstrate that a feasible government spending policy, which maintains a constant ratio to GDP, approximates the optimal policy and achieves a second-best outcome.