Spending, Taxes and Real Exchange Rates

Abstract

This paper develops a rigorous analytical framework suitable for the analysis of the effects of spending and tax policies on the world economy. It modifies the conventional conclusions according to which a budget deficit or a temporary current rise in government spending typically tend to raise interest rates. It is shown that by incorporating nontradable goods and distortionary taxes the direction of the effects of fiscal policies on interest rates and real exchange rates depend upon the timing and composition of government spending and on whether the budget deficit is financed through Income or value added taxes.

JEL Classification: 4312, 3210