Fiscal DSGE Model for Latvia
We develop a fiscal DSGE model tailored to Latvia, a small open economy in a monetary union, for the purposes of policy simulation and scenario analysis. The fiscal sector elements comprise government investment, government consumption, government transfers that are asymmetrically directed to both optimizing and hand-to-mouth households, cyclical unemployment benefits, foreign ownership of government debt, import content in public consumption and investment, and fiscal rules for each fiscal instrument. The model features a search-and-matching labour market friction with pro-cyclical labour costs, a financial accelerator mechanism, and import content in final goods. We estimate the model using Latvian data, study the new channels in the model, and provide a comprehensive analysis on the macroeconomic effects of the fiscal elements. A particular finding is that having foreign-owned government debt generally breaks the Ricardian equivalence paradigm.
Keywords: small open economy, fiscal policy, fiscal rules, Bayesian estimation
JEL codes: E0, E2, E3, F4, H2, H3, H6