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Exchange Rate Regime, Fiscal Foresight and the Effectiveness of Fiscal Policy in a Small Open Economy

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  • Virkola, Tuomo
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    Abstract

    This paper studies the effects of discretionary fiscal policy shocks under different exchange rate regimes within a structural vector autoregressive (SVAR) model. We first suggest that by estimating the effects of fiscal policy shocks in two structurally similar small open economies that have opted for different monetary policy regimes (Finland and Sweden), we may control for the economic environment and study the effect of exchange rate regime on fiscal policy transmission. Second, we propose to augment the baseline model with quarterly fiscal forecasts and study fiscal policy shocks under fiscal foresight, i.e., when economic agents may anticipate and respond to fiscal policy measures prior to their implementation. Our findings suggests that discretionary fiscal policy is more effective under a fixed exchange rate regime than under a floating exchange rate regime. This is consistent with the conventional wisdom inherited from the Mundell-Fleming framework and with recent evidence that suggests the effectiveness of fiscal policy depends on the degree of monetary policy accommodation. We also find evidence that unanticipated (as opposed to standard SVAR) fiscal policy shocks have a larger expansionary effect on output than in the baseline.

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    Paper provided by The Research Institute of the Finnish Economy in its series ETLA Reports with number 20.

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    Length: 66 pages
    Date of creation: 03 Mar 2014
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    Handle: RePEc:rif:report:20

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    Keywords: fiscal policy; exchange rate regime; fiscal foresight;

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