A dynamic stochastic general equilibrium fiscal model for the Colombian economy.

Fiscal Policy in a Small Open Economy with Oil

Sector and non-Ricardian Agents.

Macroeconomic stability is one of the key ingredients to enhance economic growth. Nonetheless, the development of a more integrated world during the last couple of decades has put forward the need to introduce more instruments to achieve this elusive goal. In this sense, not only the monetary policy
has a role but also the fiscal policy has gain relevance as an important element in overcoming this challenge. This is true for both developed and emerging market countries.

In the particular case of small open economies characterized by endowments of natural resources, such as oil, it is common for them to be hit by shocks that result not only in the so called Dutch disease but also in economic instability. Another characteristic that might reinforce this instability, in some of these economies, is the presence of great proportion of agents that do not have access
to capital markets to smooth consumption (non-Ricardian agents). These consumers, who receive transfers coming from higher oil revenues, consume all their disposable income period by period, which contributes to macroeconomic volatility.

Colombia is one example of this kind of small open economies with a significant size of credit constraint households and oil revenues. Even though its GDP has been growing at a positive rate, the economy as a whole has showed high economic instability since 2004. The rise in oil prices during the last decade resulted in large capital inflows coming from foreign direct investment (FDI) as a
percentage of GDP (particularly in the oil sector). FDI increased a 4.0% between 2004 and 2011 compared to a 2.2% between 1993 and 2003 (Garavito, Iregui and Ramirez, 2012). The exchange rate presented a real appreciation of 30% between 2004 and 2011. The ratio of credit to GDP increased from 46.1% in 2004 to 67.7% in 2008. Something similar occurred with asset prices, whose real index went from 140.0 to 416.4 in the same period. Finally, economic growth went from 3.5 % in 2005 to 7.5% in 2007 and slowed down to 0.1% during 2009; but the bubble remerged fueled by capital
inflows in 2011.

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