Fiscal Regimes and the Exchange Rate

63 Pages Posted: 11 Jan 2022

See all articles by Nikola Mirkov

Nikola Mirkov

ITAM

Enrique Alberola

Bank of Spain- International Dept; Bank for International Settlements (BIS)

Carlos Cantú

Bank for International Settlements (BIS) - Representative Office for the Americas

Paolo Cavallino

Bank for International Settlements (BIS)

Date Written: January 10, 2022

Abstract

In this paper, we argue that the effect of monetary and fiscal policies on the exchange rate depends on the fiscal regime. A contractionary monetary (expansionary fiscal) shock can lead to a depreciation, rather than an appreciation, of the domestic currency if debt is not backed by future fiscal surpluses. We look at daily movements of the Brazilian real around policy announcements and find strong support for the existence of two regimes with opposite signs. The unconventional response of the exchange rate occurs when fiscal fundamentals are deteriorating and markets’ concern about debt sustainability is rising. To rationalize these findings, we propose a model of sovereign default in which foreign investors are subject to higher haircuts and fiscal policy shifts between Ricardian and non-Ricardian regimes. In the latter, sovereign default risk drives the currency risk premium and affects how the exchange rate reacts to policy shocks.

Keywords: exchange rate, monetary policy, fiscal policy, fiscal dominance, sovereign default

JEL Classification: E52, E62, E63, F31, F34, F41, G15

Suggested Citation

Mirkov, Nikola and Alberola, Enrique and Cantú García, Carlos and Cavallino, Paolo, Fiscal Regimes and the Exchange Rate (January 10, 2022). Swiss National Bank Working Paper No. 1/2022, Available at SSRN: https://ssrn.com/abstract=4005017 or http://dx.doi.org/10.2139/ssrn.4005017

Nikola Mirkov (Contact Author)

ITAM ( email )

Av. Camino a Santa Teresa #930
Col. Heroes de Padierna
Mexico City, D.F. 10370
Mexico

Enrique Alberola

Bank of Spain- International Dept ( email )

Alcala 50
Madrid
Spain

Bank for International Settlements (BIS) ( email )

Ruben Dario 281
Polanco, Miguel Hidalgo
Mexico City, 11580
Mexico

HOME PAGE: http://www.bis.org/author/enrique_alberola-ila.htm

Carlos Cantú García

Bank for International Settlements (BIS) - Representative Office for the Americas ( email )

Switzerland

Paolo Cavallino

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
133
Abstract Views
509
Rank
341,379
PlumX Metrics