Working Paper: CEPR ID: DP8180
Authors: Giancarlo Corsetti; Keith Kuester; Gernot Müller
Abstract: According to conventional wisdom, fiscal policy is more effective under a fixed than under a flexible exchange rate regime. In this paper we reconsider the transmission of shocks to government spending across these regimes within a standard new-Keynesian model of a small open economy. Because of the stronger emphasis on intertemporal optimization, the new-Keynesian framework requires a precise specification of fiscal and monetary policies, and their interaction, at both short and long horizons. We derive an analytical characterization of the transmission mechanism of expansionary spending policies under a peg, showing that the long-term real interest rate necessarily rises if inflation rises on impact, in response to an increase in government spending. This drives down private demand even though short-term real rates fall. As this need not be the case under floating exchange rates, the conventional wisdom needs to be qualified. Under plausible medium-term fiscal policies, government spending is not necessarily less expansionary under floating exchange rates.
Keywords: exchange rate regimes; fiscal policy; long-term rates; monetary policy; New-Keynesian models
JEL Codes: F41; F42; F43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in government spending under a peg (E62) | Rise in long-term real interest rate (E43) |
| Rise in long-term real interest rate (E43) | Drive down private demand (D12) |
| Anticipation of future spending cuts under a float (E62) | Decrease in long-term real interest rate (E43) |
| Decrease in long-term real interest rate (E43) | Increase in private demand (D12) |
| Effectiveness of fiscal policy (E62) | Dependent on exchange rate regime and anticipated future fiscal mix (F31) |
| Incomplete financial markets and limited asset market participation (G19) | Enhance effectiveness of fiscal policy (E62) |