Fiscal Shocks and Exchange Rate Movements

The paper analyzes the transmission mechanisms of fiscal shocks in a two-country general equilibrium model with sticky prices. In line with the new open macroeconomics approach we link monopolistic competition to international trade. Specifically, the model allows for both market segmentation and asymmetric preferences. We introduce money via a cash-in-advance constraint: Households need cash in order to purchase consumption goods and to pay taxes. Solving the model analytically we find that a balanced budget fiscal expansion results in an appreciation of the equilibrium exchange rate. This result stands in sharp contrast to standard open economy models with money in the utility function, that predict depreciations. The ex-change rate movement is all the more pronounced, the higher the degree of pricing-to-market and the stronger the bias for domestically produced goods. As an appreciation of the short run exchange rate implies lower competitiveness of domestic firms, production is shortened. Therefore, the deterioration of the trade balance is exacerbated. We show that the response of the terms of trade depends qualitatively on the degree of pricing-to-market whereas a home bias in consumption only rules its amplitude. Finally, our welfare analysis reveals that a fiscal expansion is a “prosper-thy-neighbor ” instrument in this model setting. Our contribution may serve as an alternative account of flexible exchange rate regimes when fiscal policy is considered a major source of exchange rate movements