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Floats, pegs and the transmission of fiscal policy

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  • Giancarlo Corsetti
  • Keith Kuester
  • Gernot J. Muller

Abstract

According to conventional wisdom, fiscal policy is more effective under a fixed than under a flexible exchange rate regime. In this paper the authors 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. The authors derive an analytical characterization of the transmission mechanism of expansionary spending policies under a peg, showing that the long-term real interest rate always rises in response to an increase in government spending if inflation rises initially. This response 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 under floating exchange rates.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 11-9.

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Date of creation: 2011
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Handle: RePEc:fip:fedpwp:11-9

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Keywords: Fiscal policy ; Monetary policy;

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References

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  1. W.H. Buiter & G Corsetti & P Pesenti, 1997. "Interpreting the ERM Crisis: Country-Specific and Systemic Issues," CEP Discussion Papers dp0321, Centre for Economic Performance, LSE.
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  4. Benigno, Gianluca & Benigno, Pierpaolo & Ghironi, Fabio, 2007. "Interest rate rules for fixed exchange rate regimes," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2196-2211, July.
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  7. Jordi Galí & Mark Gertler & J. David López-Salido, 2000. "European Inflation Dynamics," Banco de Espa�a Working Papers 0020, Banco de Espa�a.
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  18. Gernot Müller & Giancarlo Corsetti & André Meier, 2009. "Fiscal Stimulus with Spending Reversals," IMF Working Papers 09/106, International Monetary Fund.
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Citations

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Cited by:
  1. Dennis Bonam & Jasper Lukkezen, 2013. "Government spending shocks, sovereign risk and the exchange rate regime," Working Papers 14-01, Utrecht School of Economics.
  2. Emmanuel Farhi & Iván Werning, 2012. "Fiscal Multipliers: Liquidity Traps and Currency Unions," NBER Working Papers 18381, National Bureau of Economic Research, Inc.
  3. 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, vol. 204(1), pages 113-139, March.
  4. Gabriela Lopes de Castro & Ricardo Mourinho Félix & Paulo Júlio & José R. Maria, 2013. "Fiscal multipliers in a small euro area economy: How big can they get in crisis times?," Working Papers w201311, Banco de Portugal, Economics and Research Department.
  5. Dennis Bonam & Jasper Lukkezen, 2013. "Government Spending Shocks, Sovereign Risk and the Exchange Rate Regime," Tinbergen Institute Discussion Papers 13-212/VI, Tinbergen Institute, revised 09 Jan 2013.
  6. 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.

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