Government spending during sudden stop crises

This paper examines the state-dependent multipliers of government spending in sudden stop economies. First, I provide cross-country evidence that an increase in government spending is more effective in stimulating consumption and appreciating the real exchange rate in sudden stop crises than in normal times. To rationalize this, I then build a small open economy model with a collateral constraint on international borrowing. During a financial crisis, an adverse international shock reduces consumption and lowers the market value of income as collateral. The lowered income, in turn, tightens the financial constraint and sets in a debt-deflation mechanism. In this context, a fiscal expansion appreciates the real exchange rate and drives in capital flows when the financial constraint is binding, thus creating a larger multiplier on private consumption. The difference in multipliers across financial states also depends on the exchange rate environment of a country.