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Date Published:Jan 10, 2006
We study a small open economy characterized by two empirically important frictions—incomplete financial markets and an inability of the government to commit to policy. We characterize the best sustainable fiscal policy and show that it can amplify and prolong shocks to output. In particular, even when the government is completely benevolent, the government’s credibility not to expropriate capital endogenously varies with the state of the economy and may be "scarcest" during recessions. This increased threat of expropriation depresses investment, prolonging downturns. It is the incompleteness of financial markets and lack of commitment that generate investment cycles even in an environment where first best capital stock is constant.