Profitability, Fiscal Policy and Exchange Rate Regimes

CEPR Discussion Paper Series 1449

Posted: 9 Jan 1997

See all articles by Roberto Perotti

Roberto Perotti

Bocconi University - Department of Economics; European University Institute - Economics Department (ECO); Centre for Economic Policy Research (CEPR)

Philip R. Lane

Trinity College (Dublin) - Department of Economics; Centre for Economic Policy Research (CEPR); Central Bank of Ireland

Date Written: July 1996

Abstract

In this paper, we study the link between profitability, fiscal policy and exchange rate regimes. We are particularly interested in adding realism to the treatment of fiscal policy by looking explicitly at its individual components. We show that the different types of government spending and taxation affect profitability through two main channels, namely changes in labor costs and movements in the nominal exchange rate when the exchange rate is flexible. This also implies that the different components of fiscal policy have different effects on profitability depending on the exchange rate regime. Using a panel of OECD countries over 1960-94, we find considerable empirical support for the predictions of our model. Increases in government wage consumption lead to higher labor costs and a nominal exchange rate appreciation; hence, they have a stronger negative impact on profitability under a flexible exchange rate regime. The opposite holds for increases in labor taxation. In contrast, and in line with our model, government non-wage consumption and transfers have only minor effects on exchange rates and profitability, and regime effects are small in these cases. The implication for countries attempting a fiscal adjustment is that its impact on profitability depends critically on the composition of the fiscal adjustment and on the exchange rate policy.

JEL Classification: E62, F33

Suggested Citation

Perotti, Roberto and Lane, Philip R., Profitability, Fiscal Policy and Exchange Rate Regimes (July 1996). CEPR Discussion Paper Series 1449. Available at SSRN: https://ssrn.com/abstract=3737

Roberto Perotti (Contact Author)

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

European University Institute - Economics Department (ECO) ( email )

Villa San Paolo
Via della Piazzuola 43
50133 Florence
Italy

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Philip R. Lane

Trinity College (Dublin) - Department of Economics ( email )

Trinity College
Dublin 2
Ireland
+353 1 608 2259 (Phone)
+353 1 677 2503 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Central Bank of Ireland ( email )

P.O. Box 559
Dame Street
Dublin, 2
Ireland

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