Floats, Pegs and the Transmission of Fiscal Policy

Giancarlo Corsetti (1) , Keith Kuester (2) , Gernot Müller (3)
(1) , Chile
(2) , Chile
(3) , Chile

Abstract

According to conventional wisdom, fiscal policy is more effective under a fixed exchange rate regime than under a flexible one. 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 in a floating regime.

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Authors

Giancarlo Corsetti
Keith Kuester
Gernot Müller
Corsetti, G. ., Kuester , K. ., & Müller, . G. . (2011). Floats, Pegs and the Transmission of Fiscal Policy. ECONOMÍA CHILENA, 14(2), 5–38. https://doi.org/10.36923/economa.v14i2.145

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