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Can a fiscal contraction strengthen a currency?: Some doubts about conventional Mundell-Fleming results

  • Richard Cantor
  • Robert Driskill

This article demonstrates that a fiscal expansion can induce both a short- and long-run depreciation of a currency and, by parallel arguments, fiscal contraction can induce short- and long-run appreciation. This possibility hinges on a country being a debtor with at least some of its debt servicing costs reset periodically in response to changes in its domestic interest rates. In the simpler version of our model, we show that a fiscal expansion can lead to an instantaneous depreciation and a current account deficit, causing the currency to continue to depreciate over time. The current account deficit develops despite the currency depreciation because debt service payments increase due to the higher interest rates induces by the fiscal stimulus. The second version of our model assumes the trade deficit responds with a lag to relative prices. This model implies that expansionary fiscal policy may induce not only a currency depreciation and a current account deterioration, but a widening of the trade deficit as well. In both models, an instantaneous depreciation following a fiscal expansion becomes more likely if a country's net external debt is large.

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Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9629.

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Date of creation: 1996
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Handle: RePEc:fip:fednrp:9629
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  1. Giuseppe Bertola & Allan Drazen, 1991. "Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity," NBER Working Papers 3844, National Bureau of Economic Research, Inc.
  2. Frenkel, Jacob A & Razin, Assaf, 1986. "Fiscal Policies in the World Economy," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages 564-94, June.
  3. Barro, Robert J., 1974. "Are Government Bonds Net Wealth?," Scholarly Articles 3451399, Harvard University Department of Economics.
  4. Krugman, Paul, 1989. "The J-Curve, the Fire Sale, and the Hard Landing," American Economic Review, American Economic Association, vol. 79(2), pages 31-35, May.
  5. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  6. Jeffrey Sachs & Charles Wyplosz, 1984. "Real Exchange Rate Effects of Fiscal Policy," NBER Working Papers 1255, National Bureau of Economic Research, Inc.
  7. Kawai, Masahiro & Maccini, Louis J, 1995. "Twin Deficits versus Unpleasant Fiscal Arithmetic in a Small Open Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(3), pages 639-58, August.
  8. Evans, Paul, 1986. "Is the dollar high because of large budget deficits?," Journal of Monetary Economics, Elsevier, vol. 18(3), pages 227-249, November.
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