Floats, Pegs and the Transmission of Fiscal Policy

35 Pages Posted: 18 Jan 2011

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Gernot J. Müller

University of Tuebingen - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: January 2011

Abstract

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.

Keywords: Exchange rate regimes, Fiscal Policy, Long-term rates, Monetary Policy, New-keynesian models

JEL Classification: F41, F42, F43

Suggested Citation

Corsetti, Giancarlo and Kuester, Keith and Müller, Gernot J., Floats, Pegs and the Transmission of Fiscal Policy (January 2011). CEPR Discussion Paper No. DP8180, Available at SSRN: https://ssrn.com/abstract=1742725

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
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Centre for Economic Policy Research (CEPR)

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Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

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Philadelphia, PA 19106-1574
United States

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

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D-72074 Tuebingen, 72074
Germany

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