Floats, Pegs and the Transmission of Fiscal Policy

Giancarlo Corsetti, Keith Kuester and Gernot Müller

Journal Economía Chilena (The Chilean Economy), 2011, vol. 14, issue 2, 5-38

Abstract: According to conventional wisdom, fiscal policy is more effective under a fixed exchange rate regime than under a flexible one. 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 in a floating regime.

Date: 2011
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Related works:
Chapter: Floats, Pegs and the Transmission of Fiscal Policy (2013)
Working Paper: Floats, Pegs and the Transmission of Fiscal Policy (2011)
Working Paper: Floats, pegs and the transmission of fiscal policy (2011)
Working Paper: Floats, pegs and the transmission of fiscal policy (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:chb:bcchec:v:14:y:2011:i:2:p:5-38

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