Discussion paper

DP8180 Floats, pegs and the transmission of fiscal policy

According to conventional wisdom, fiscal policy is more effective under a fixed than under a flexible exchange rate regime. In this paper we reconsider the transmission of shocks to government spending across these regimes within a standard new-Keynesian model of a small open economy. Because of the stronger emphasis on intertemporal optimization, the new-Keynesian framework requires a precise specification of fiscal and monetary policies, and their interaction, at both short and long horizons. We derive an analytical characterization of the transmission mechanism of expansionary spending policies under a peg, showing that the long-term real interest rate necessarily rises if inflation rises on impact, in response to an increase in government spending. This drives down private demand even though short-term real rates fall. As this need not be the case under floating exchange rates, the conventional wisdom needs to be qualified. Under plausible medium-term fiscal policies, government spending is not necessarily less expansionary under floating exchange rates.

£6.00
Citation

Corsetti, G, G Müller and K Kuester (2011), ‘DP8180 Floats, pegs and the transmission of fiscal policy‘, CEPR Discussion Paper No. 8180. CEPR Press, Paris & London. https://cepr.org/publications/dp8180