Floats, Pegs and the Transmission of Fiscal Policy

34 Pages Posted: 24 Feb 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: February 15, 2011

Abstract

According to conventional wisdom, fiscal policy is more effective under a fixed than under a flexible exchange rate regime. In this paper the authors 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. The authors derive an analytical characterization of the transmission mechanism of expansionary spending policies under a peg, showing that the long-term real interest rate always rises in response to an increase in government spending if inflation rises initially. This response 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: Fiscal policy,Monetary policy, Exchange rate regime, Long-term rates, New Keynesian models

JEL Classification: F41, F42, E32

Suggested Citation

Corsetti, Giancarlo and Kuester, Keith and Müller, Gernot J., Floats, Pegs and the Transmission of Fiscal Policy (February 15, 2011). FRB of Philadelphia Working Paper No. 11-9, Available at SSRN: https://ssrn.com/abstract=1767414 or http://dx.doi.org/10.2139/ssrn.1767414

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

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Rome, 00154
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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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