DP14073 The worst of both worlds: Fiscal policy and fixed exchange rates

Author(s): Benjamin Born, Francesco D'Ascanio, Gernot Müller, Johannes Pfeifer
Publication Date: October 2019
Keyword(s): asymmetric adjustment, Downward Nominal Wage Rigidity, Exchange rate peg, Government Spending Shocks, Non-linear effects, output, real exchange rate
JEL(s): E62, F41, F44
Programme Areas: International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14073

Under fixed exchange rates, fiscal policy is an effective tool. According to classical views because it impacts the real exchange rate, according to Keynesian views because it impacts output. Both views have merit because the effects of government spending are asymmetric. A spending cut lowers output but does not alter the real exchange rate. A spending increase appreciates the exchange rate but does not alter output unless there is economic slack. We establish these results in a small open economy model with downward nominal wage rigidity and provide empirical evidence on the basis of quarterly time-series data for 38 countries.