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Floats, Pegs and the Transmission of Fiscal Policy

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  • Giancarlo Corsetti
  • Keith Kuester
  • Gernot J. Müller

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.

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Bibliographic Info

Article provided by Central Bank of Chile in its journal Economía Chilena.

Volume (Year): 14 (2011)
Issue (Month): 2 (August)
Pages: 5-38

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Handle: RePEc:chb:bcchec:v:14:y:2011:i:2:p:5-38

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  1. Gernot Müller & André Meier & Giancarlo Corsetti, 2012. "What Determines Government Spending Multipliers?," IMF Working Papers 12/150, International Monetary Fund.
  2. Giancarlo Corsetti & André Meier & Gernot J. Müller, 2012. "What determines government spending multipliers?," Economic Policy, CEPR;CES;MSH, CEPR;CES;MSH, vol. 27(72), pages 521-565, October.
  3. Buiter, W.H. & Corsetti, G.M. & Pesenti, P.A., 1998. "Interpreting the ERM Crisis: Country-Specific and Systemic Issues," Princeton Studies in International Economics, International Economics Section, Departement of Economics Princeton University, 84, International Economics Section, Departement of Economics Princeton University,.
  4. Jordi Galí & J. David López-Salido, 2003. "Understanding the Effects of Government Spending on Consumption," Working Papers 73, Barcelona Graduate School of Economics.
  5. Gernot Müller & Giancarlo Corsetti & André Meier, 2009. "Fiscal Stimulus with Spending Reversals," IMF Working Papers 09/106, International Monetary Fund.
  6. Jordi Galí & Tommaso Monacelli, 2005. "Optimal monetary and fiscal policy in a currency union," Economics Working Papers 909, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2008.
  7. Galí, Jordi & Gertler, Mark & López-Salido, J David, 2001. "European Inflation Dynamics," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2684, C.E.P.R. Discussion Papers.
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  9. Bianca De Paoli, 2004. "Monetary policy and welfare in a small open economy," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 19950, London School of Economics and Political Science, LSE Library.
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  13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
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  15. Bilbiie, Florin O. & Meier, André & Müller, Gernot J., 2006. "What accounts for the changes in U.S. fiscal policy transmission?," Working Paper Series, European Central Bank 0582, European Central Bank.
  16. Giancarlo Corsetti & André Meier & Gernot J. Müller, 2012. "Fiscal Stimulus with Spending Reversals," The Review of Economics and Statistics, MIT Press, vol. 94(4), pages 878-895, November.
  17. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 123(4), pages 1415-1464, November.
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  19. Giancarlo Corsetti & Keith Kuester & André Meier & Gernot J. Müller, 2010. "Debt Consolidation and Fiscal Stabilization of Deep Recessions," American Economic Review, American Economic Association, American Economic Association, vol. 100(2), pages 41-45, May.
  20. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2011. "When Is the Government Spending Multiplier Large?," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 119(1), pages 78 - 121.
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Cited by:
  1. Emmanuel Farhi & Iván Werning, 2012. "Fiscal Multipliers: Liquidity Traps and Currency Unions," NBER Working Papers 18381, National Bureau of Economic Research, Inc.
  2. Dennis Bonam & Jasper Lukkezen, 2013. "Government spending shocks, sovereign risk and the exchange rate regime," Working Papers, Utrecht School of Economics 14-01, Utrecht School of Economics.
  3. Ricardo Félix & Gabriela Castro & José Maria & Paulo Júlio, 2013. "Fiscal Multipliers in a Small Euro Area Economy: How Big Can They Get in Crisis Times?," EcoMod2013 5307, EcoMod.
  4. Luiz de Mello, 2013. "What Can Fiscal Policy Do in the Current Recession? A Review of Recent Literature and Policy Options," Hacienda Pública Española, IEF, IEF, vol. 204(1), pages 113-139, March.
  5. Jasper Lukkezen & Dennis Bonam (VU and Tinbergen), 2014. "Government spending shocks, sovereign risk and the exchange rate regime," CPB Discussion Paper 263, CPB Netherlands Bureau for Economic Policy Analysis.
  6. Dennis Bonam & Jasper Lukkezen, 2013. "Government Spending Shocks, Sovereign Risk and the Exchange Rate Regime," Tinbergen Institute Discussion Papers 13-212/VI, Tinbergen Institute.

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