Floats, Pegs And The Transmission Of Fiscal Policy

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According to conventional wisdom, fiscal policy is more effective under a fixed than under a flexible exchange rate regime. In this paper the authors reconsider the transmission of shocks to government spending across these regimes within a standard New Keynesian model of a small open economy. Because of the stronger emphasis on intertemporal optimization, the New Keynesian framework requires a precise specification of fiscal and monetary policies, and their interaction, at both short and long horizons. They derive an analytical characterization of the transmission mechanism of expansionary spending policies under a peg, showing that the long-term real interest rate always rises in response to an increase in government spending if inflation rises initially.