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Fiscal Stabilization With Partial Exchange Rate Pass-Through

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Executive Summary

This paper examines the role of fiscal stabilization policy in a two-country framework that allows for a general degree of exchange rate pass-through. The author derives analytical solutions for optimal monetary and fiscal policy which are shown to depend on the degree of pass-through. In the case of partial pass-through, an optimizing policy maker uses counter-cyclical fiscal stabilization in addition to monetary stabilization. However, in the extreme cases of complete or zero pass-through, the fiscal stabilization instrument is not employed. There is also no additional gain from the fiscal instrument in the case of coordination between the two countries.

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