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Fiscal dominance, shocks, and the currency distribution of sovereign debt: the case of a small open economy

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  • Di Iorio Juan Pablo

Abstract

This study examines the effects of incorporating fiscal dominance, based on the Fiscal Theory of the Price Level, into a New Keynesian Small Open Economy (NK-SOE) model. This framework enables a comparison between the responses of an economy characterized by fiscal dominance and those of canonical NK-SOE models when faced with monetary or external shocks. Notable differences emerge in nominal variables, such as inflation rates and nominal devaluation, as well as in household consumption and the real exchange rate. I show that introducing fiscal dominance into an otherwise standard NK-SOE model can help explain two important puzzles in the literature: the “price puzzle” and the “exchange rate response puzzle.” Furthermore, the model is expanded to account for government debt issued in foreign currency, introducing a fiscal channel related to the currency composition of the government’s debt. Additionally, the structure of taxes and government expenditures—particularly fiscal revenues tied to the non-tradable sector—plays a significant role in shaping the economic response when the government issues debt in foreign currency.

Suggested Citation

  • Di Iorio Juan Pablo, 2025. "Fiscal dominance, shocks, and the currency distribution of sovereign debt: the case of a small open economy," Asociación Argentina de Economía Política: Working Papers 4794, Asociación Argentina de Economía Política.
    • Handle: RePEc:aep:anales:4794
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    JEL classification:

    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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