Fiscal Theory of the Price Level in Small and Open Economies

A salient feature of many emerging and developing economies is that a substantial fraction of government debt is denominated in foreign currency. We study the implications of the Fiscal Theory of the Price Level (FTPL) in a standard New Keynesian small and open economy model, with an explicit role for the currency denomination of public debt. We show that, while the classical FTPL characterization of equilibrium existence and uniqueness extends largely independently of debt composition, the propagation of shocks does not. The currency denomination of public liabilities alters the effects of monetary and fiscal policy, including the possibility that a monetary tightening leads to a depreciation under active fiscal regimes. More broadly, the interaction between the fiscal-monetary policy mix and the share of foreign-currency debt also plays a central role in shaping the response to external shocks.