The Worst of Both Worlds: Fiscal Policy and Fixed Exchange Rates
50 Pages Posted: 27 Nov 2019
Date Written: 2019
Under fixed exchange rates, fiscal policy is an effective tool. According to classical views because it impacts the real exchange rate, according to Keynesian views because it impacts output. Both views have merit because the effects of government spending are asymmetric. A spending cut lowers output but does not alter the real exchange rate. A spending increase appreciates the exchange rate but does not alter output unless there is economic slack. We establish these results in a small open economy model with downward nominal wage rigidity and provide empirical evidence on the basis of quarterly time-series data for 38 countries.
Keywords: downward nominal wage rigidity, government spending shocks, exchange rate peg, real exchange rate, output, non-linear effects, asymmetric adjustment
JEL Classification: E620, F410, F440
Suggested Citation: Suggested Citation