# 13-212/VI (2013-01-07; 2013-01-09)

Dennis Bonam, VU University Amsterdam, the Netherlands; Jasper Lukkezen, Utrecht University, Utrecht, and CPB Netherlands Bureau for Economic Policy Analysis, the Netherlands
Fiscal policy, government spending, exchange rate regime, sovereign risk, New Keynesian model, expansionary fiscal consolidation
JEL codes:
E32, E52, E62

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.