This paper presents a quantitative analysis of the way in which a government finances its fiscal deficit in a small open economy. In particular, it focuses on the evaluation of the macroeconomic impact of a situation in which, given a fiscal deficit, the government decides whether to finance it with domestic or external debt. For this purpose a small open economy DSGE model is used. The model is calibrated to the colombian economy. The results depend on whether the substitution is transitory or permanent. The former has negligible macroeconomic effects, except for the impact on private capital flows (we call this a «portfolio effect»). An increase in the domestic public debt equally matched by a reduction in the external debt, is balanced by a reduction in private net foreign assets. On the contrary, a permanent substitution of 10% in the level of external public debt by domestic debt, has transitory but significant effects on the level of real economic activiTY and capital flows. Such a recomposition generates a 5% increase in net foreign assets (a capital outflow) along with a 1% nominal nominal depreciation. Although our results are quite general under flexible prices, we especulate that they may change in the presence of uncertainTY about the sustainabiliTY of fiscal deficit and/or nominal and real rigidities.
