Government spending shocks, sovereign risk and the exchange rate regime

Jasper Lukkezen and Dennis Bonam

No 263, CPB Discussion Paper from CPB Netherlands Bureau for Economic Policy Analysis

Abstract: Keynesian theory predicts output responses upon a fiscal expansion in a small open economy to be larger under fixed than under 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 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.

JEL-codes: E32 E52 E62 (search for similar items in EconPapers)
Date: 2014-01
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Citations: View citations in EconPapers (3)

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