In this article, we examine the effects of an investment tax credit (ITC) in a small, open, developing economy with external debt and sovereign risk. The risk premium on foreign loans depends on the debt–income ratio. We show that an increase in the rate of an ITC leads to an increase in aggregate consumption, capital accumulation, foreign debt and output in the long run. Despite the fact that there is insignificant long‐run effect, employment exhibits significant transitional dynamics. Moreover, our results show that the accumulation of foreign debt exhibits non‐monotonic adjustment. Particularly, an increase in the ITC leads to a current account deficit followed by a surplus. Along with this non‐monotonicity, our model also explains the positive correlation between savings and investment during the transitional periods. We have also worked out the effects of temporary ITC policies.

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This paper uses an intertemporal optimizing model with country‐specific risk premium to evaluate the real effects of inflation in a small open developing economy. In the model, a central bank targets inflation, and the consumer requires real balances in advance for consumption spending. We show that a positive inflation shock (either due to growth in money supply or depreciation of the domestic currency) yields a decrease in real output and consumption—as inflation creates a tax wedge in the intratemporal condition between consumption and leisure—leading to a decrease in the stock of real debt in domestic currency. Employing these theoretical predictions and using annual data from a set of six developing countries (Chile, Ghana, Indonesia, Kenya, Malaysia and Thailand), we estimate a sign‐restriction based structural vector autoregression model along with a panel vector autoregression model for robustness analysis. The empirical results support the trade‐off of inflation with reference to the key real variables including the external debt position, which is a significant result given the ambiguity in the empirical literature as to whether governments can escape from debt crisis via higher inflation. Copyright © 2016 John Wiley & Sons, Ltd.