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.
# 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