Recent empirical findings attribute a central role to the degree of economic openness for determining the size of the fiscal multiplier. However, traditional macroeconomic models have difficulties in accounting for this evidence. It is the purpose of this paper to provide a theoretical framework which is able to attest for the new empirical evidence. To this end, we introduce the formation of "deep habits" into a New Keynesian small open economy model and give an active role to monetary policy. The presence of counter-cyclical firm markups is a crucial ingredient to generating a fiscal multiplier of empirically consistent size which is influenced by openness. We study three dimensions of economic openness: Exchange rate flexibility, trade openness and capital mobility. In line with the empirical findings, we report a negative relationship with the fiscal multiplier.
fiscal multiplier exchange rate flexibility openness to trade capital mobility