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Government spending shocks, sovereign risk and the exchange rate regime

Listed author(s):
  • D. Bonam
  • J.H.J. Lukkezen

Keynesian theory predicts output responses upon a fiscal expansion in a small open economy to be larger under fixed than floating exchange rates. We analyse the effects of fiscal expansions using a New Keynesian model and find that the reverse holds in the presence of sovereign default risk. By raising sovereign risk, a fiscal expansion worsens private credit conditions and reduces consumption; these adverse effects are offset by an exchange rate depreciation and a rise in exports under a float, yet not under a peg. We find that output responses can even be negative when exchange rates are held fixed, suggesting the possibility of expansionary fiscal consolidations.

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Paper provided by Utrecht School of Economics in its series Working Papers with number 14-01.

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Date of creation: 2014
Handle: RePEc:use:tkiwps:1401
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