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