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Floats, Pegs and the Transmission of Fiscal Policy

  • Giancarlo Corsetti
  • Keith Kuester
  • Gernot J. Müller

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.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 608.

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Date of creation: Jan 2011
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Handle: RePEc:chb:bcchwp:608
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