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Default on Government Debt and Exchange Rate Dynamics

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  • Timo Henckel

Abstract

This paper investigates how government debt affects exchange rate behavior. In a two-country general-equilibrium setting, it shows that the exchange rate is directly related to the effective price of public debt. Changes in the present value of the stream of future surpluses alter the expected returns and market value of securities. If the price of securities is fixed in terms of money, the private sector will attempt to rebalance its portfolio in favor of safe (foreign) securities. However, when prices are sticky part of the adjustment must come through the exchange rate. A key result is that a mean-preserving increase in the variance of future fiscal policy affects current consumption, prices, current accounts, and the exchange rate immediately. In other words, not only first moments of future policy are important, but second moments too. As a subplot, the paper briefly discusses the fiscal theory of the price level and provides some examples to disprove this flawed theory

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 Australasian Meetings with number 269.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:ausm04:269

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Keywords: debt; exchange rates; default; fiscal policy;

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