Fiscal DSGE model for Latvia

ABSTRACT We develop a fiscal dynamic stochastic general equilibrium (DSGE) model for policy simulation and scenario analysis purposes tailored to Latvia, a small open economy in a monetary union. The fiscal sector elements comprise public investment, public consumption, government transfers that are asymmetrically directed to both optimizing and restricted (hand-to-mouth) households, cyclical unemployment benefits, foreign ownership of public 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. Our results indicate that Latvian fiscal policy was pro-cyclical during the boom-bust period of 2004–2010 and that foreign ownership of public debt breaks Ricardian equivalence and raises fiscal multipliers.