Abstract
Keynesian theory predicts output responses upon a fiscal expansion in a small
open economy to be larger under fixed than floating exchange rates. We analyse
the effects of fiscal expansions using a New Keynesian model and find
that the reverse holds in the presence of sovereign default risk. By raising sovereign
risk, a fiscal expansion worsens private credit conditions and reduces
consumption; these adverse effects are offset by an exchange rate depreciation
and a rise in exports under a float, yet not under a peg. We find that output
responses can even be negative when exchange rates are held fixed, suggesting
the possibility of expansionary fiscal consolidations.
open economy to be larger under fixed than floating exchange rates. We analyse
the effects of fiscal expansions using a New Keynesian model and find
that the reverse holds in the presence of sovereign default risk. By raising sovereign
risk, a fiscal expansion worsens private credit conditions and reduces
consumption; these adverse effects are offset by an exchange rate depreciation
and a rise in exports under a float, yet not under a peg. We find that output
responses can even be negative when exchange rates are held fixed, suggesting
the possibility of expansionary fiscal consolidations.
| Original language | English |
|---|---|
| Publisher | UU USE Tjalling C. Koopmans Research Institute |
| Publication status | Published - 2014 |
Publication series
| Name | Discussion Paper Series / Tjalling C. Koopmans Research Institute |
|---|---|
| No. | 01 |
| Volume | 14 |
| ISSN (Electronic) | 2666-8238 |
Keywords
- Fiscal policy
- government spending
- exchange rate regime
- sovereign risk
- New Keynesian model
- expansionary fiscal consolidation