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Floats, Pegs and the Transmission of Fiscal Policy

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Listed:
  • 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.

Suggested Citation

  • Giancarlo Corsetti & Keith Kuester & Gernot J. Müller, 2011. "Floats, Pegs and the Transmission of Fiscal Policy," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 14(2), pages 5-38, August.
  • Handle: RePEc:chb:bcchec:v:14:y:2011:i:2:p:5-38
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    References listed on IDEAS

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    Cited by:

    1. Lemoine, Matthieu & Lindé, Jesper, 2016. "Fiscal consolidation under imperfect credibility," European Economic Review, Elsevier, vol. 88(C), pages 108-141.
    2. Cook, David & Devereux, Michael B, 2016. "Exchange rate flexibility under the zero lower bound," Journal of International Economics, Elsevier, vol. 101(C), pages 52-69.
    3. Sylvain Leduc & Daniel Wilson, 2013. "Roads to Prosperity or Bridges to Nowhere? Theory and Evidence on the Impact of Public Infrastructure Investment," NBER Macroeconomics Annual, University of Chicago Press, vol. 27(1), pages 89-142.
    4. Emmanuel Farhi & Ivan Werning, "undated". "Fiscal Multipliers: Liquidity Traps and Currency Unions," Working Paper 78556, Harvard University OpenScholar.
    5. Kuvshinov, Dmitry & Müller, Gernot J. & Wolf, Martin, 2016. "Deleveraging, deflation and depreciation in the euro area," European Economic Review, Elsevier, vol. 88(C), pages 42-66.
    6. Marie-Pierre Hory, 2016. "Fiscal multipliers in Emerging Market Economies: Can we learn something from Advanced Economies?," International Economics, CEPII research center, issue 146, pages 59-84.
    7. 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.
    8. 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.
    9. repec:eee:macchp:v2-2417 is not listed on IDEAS
    10. Sly, Nicholas & Weber, Caroline, 2015. "Global tax policy and the synchronization of business cycles," Research Working Paper RWP 15-7, Federal Reserve Bank of Kansas City.
    11. 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.
    12. Ma, Yong, 2016. "Nonlinear monetary policy and macroeconomic stabilization in emerging market economies: Evidence from China," Economic Systems, Elsevier, vol. 40(3), pages 461-480.
    13. repec:oup:oxford:v:34:y:2018:i:1-2:p:269-286. is not listed on IDEAS

    More about this item

    JEL classification:

    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
    • F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies

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