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Fiscal regimes and the exchange rate

Enrique Alberola-Ila, Carlos Cantu Garcia (), Paolo Cavallino and Nikola Mirkov

No 950, BIS Working Papers from Bank for International Settlements

Abstract: In this paper, we argue that the effect of monetary and fiscal policies on the exchange rate depends on the fiscal regime. A contractionary monetary (expansionary fiscal) shock can lead to a depreciation, rather than an appreciation, of the domestic currency if debt is not backed by future fiscal surpluses. We look at daily movements of the Brazilian real around policy announcements and find strong support for the existence of two regimes with opposite signs. The unconventional response of the exchange rate occurs when fiscal fundamentals are deteriorating and markets' concern about debt sustainability is rising. To rationalize these findings, we propose a model of sovereign default in which foreign investors are subject to higher haircuts and fiscal policy shifts between Ricardian and non-Ricardian regimes. In the latter, sovereign default risk drives the currency risk premium and affects how the exchange rate reacts to policy shocks.

Keywords: exchange rate; monetary policy; fiscal policy; fiscal dominance; sovereign default (search for similar items in EconPapers)
JEL-codes: E52 E62 E63 F31 F34 F41 G15 (search for similar items in EconPapers)
Pages: 61 pages
Date: 2021-06
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-opm
References: View references in EconPapers View complete reference list from CitEc
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