Working Paper: NBER ID: w2065
Authors: Jacob A. Frenkel; Assaf Razin
Abstract: This paper examines the effects of fiscal policies on the evolution of real rates of interest and real exchange rates in the interdependent world economy. We construct an analytical framework suitable for a detailed examination of the various channels through which these variables are influenced by government spending and by tax policies. The analytical framework employs a general equilibrium approach highlighting the roles played by wealth effects and by temporal and intertemporal substitution effects. The general principle illustrated by the analysis of the dynamic effects of budget deficits is that the consequences of temporary tax policies stretch beyond the period during which the temporary policies are in effect. The counterpart to these dynamic implications is the rise in the economy's external debt induced by the budget deficit the service of which stretches into the indefinite future. By series of examples, allowing for both distortionary and non-distortionary taxes and for various patterns of government spending, it is shown that the quantitative and qualitative effects of fiscal policies on real exchange rates, real interest rates, debt accumulation and the like depend critically on the commodity composition of government spending and its intertemporal allocations on the one hand, and on the details of government debt issue and tax structure, including the timing of taxes and borrowing and the types of taxes used to finance the budget, on the other hand.
Keywords: Fiscal Policies; Real Exchange Rates; Interest Rates; International Economics
JEL Codes: E62; F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government spending (H59) | real exchange rates (F31) |
| government spending (H59) | real interest rates (E43) |
| increase in government spending on nontradable goods (H59) | current price of nontradable goods relative to future prices (Q31) |
| temporary tax policies (H26) | external debt accumulation (F34) |
| budget deficits (H62) | real exchange rates (F31) |
| budget deficits (H62) | real interest rates (E43) |
| wealth effects (E21) | effectiveness of fiscal policies (H30) |
| intertemporal substitution effects (D15) | effectiveness of fiscal policies (H30) |