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Fiscal Policy and Welfare under Different Exchange Rate Regimes

  • Østrup, Finn

    (Department of Finance, Copenhagen Business School)

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    The article analyses how government spending is determined under different exchange rate regimes in the context of a small open economy. Assuming nominal wage contracts which last for one period and assuming a benevolent government which determines government spending to optimise a representative individual’s utility, it is demonstrated that there are differences between exchange rate regimes with respect to the level of government spending. These differences arise first because a rise in government spending affects macroeconomic variables differently under different exchange rate regimes, and second because the government’s inclination to expand government spending is affected by inflation which depends on the exchange rate regime. At low rates of inflation, the government is inclined to set a higher level of government spending under a fixed exchange rate regime than under a floating exchange rate regime in which the monetary authority optimises preferences which include an employment target and an inflation target. As government spending affects the representative individual’s utility, the choice of exchange rate regime has an impact on welfare.

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    Paper provided by Copenhagen Business School, Department of Finance in its series Working Papers with number 2005-1.

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    Length: 26 pages
    Date of creation: 19 May 2005
    Date of revision:
    Handle: RePEc:hhs:cbsfin:2005_001
    Contact details of provider: Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark
    Phone: +45 3815 3815
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