Fiscal Stance and the Real Exchange: Some Empirical Estimates

Richard Clarida and Joe Prendergast

No 7077, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper presents some empirical results on the dynamic relationship between fiscal policy and the real exchange rate in the G3 countries since advent of floating exchange rates. This subject is of some interest given the recent shift to fiscal surpluses in the US, the annual announcement of yet another fiscal stimulus package in Japan, and Maastricht limits on fiscal deficits in Germany and the rest of Euroland. To the extent that the foreign exchange market anticipates that fiscal contractions will follow expansions,' as would be required by the government's intertemporal budget constraint when holding constant the present value of tax collections, it is possible that the exchange rate response to any contemporaneous index of fiscal stance will depend upon exactly what stage the government's fiscal cycle' is (thought to be) in. We find a similarity across the G3 countries in their estimated dynamic responses to a fiscal shock. At first, and for several years thereafter, the real exchange rate appreciates in response to an expansionary fiscal shock. However, eventually, the process is reversed; the real exchange rate overshoots and actually depreciates relative to its initial prevailing before the fiscal shock.

Date: 1999-04
Note: IFM
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