Government spending shocks, sovereign risk and the exchange rate regime

Dennis Bonam and J.H.J. Lukkezen

No 14-01, Working Papers from Utrecht School of Economics

Abstract: Keynesian theory predicts output responses upon a fiscal expansion in a small open economy to be larger under fixed than floating exchange rates. We analyse the effects of fiscal expansions using a New Keynesian model and find that the reverse holds in the presence of sovereign default risk. By raising sovereign risk, a fiscal expansion worsens private credit conditions and reduces consumption; these adverse effects are offset by an exchange rate depreciation and a rise in exports under a float, yet not under a peg. We find that output responses can even be negative when exchange rates are held fixed, suggesting the possibility of expansionary fiscal consolidations.

Keywords: Fiscal policy; government spending; exchange rate regime; sovereign risk; New Keynesian model; expansionary fiscal consolidation (search for similar items in EconPapers)
Date: 2014
New Economics Papers: this item is included in nep-mac and nep-opm
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Citations: View citations in EconPapers (3)

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Related works:
Working Paper: Government spending shocks, sovereign risk and the exchange rate regime (2014)
Working Paper: Government Spending Shocks, Sovereign Risk and the Exchange Rate Regime (2013)
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