Abstract
This paper investigates the dynamic effects of fiscal and monetary feedback policy rules in a small open economy with flexible exchange rates and risk premia on external debt. It is shown that equilibrium uniqueness and stability occur under locally Ricardian fiscal policies regardless of the degree of reaction of nominal interest rates to inflation, in contrast with closed-economy environments. Fiscal revaluation mechanisms of the type predicted by the fiscal theory of the price level are precluded by international parity conditions. As a result, locally non-Ricardian fiscal policies are destabilizing even under an accommodating monetary policy stance.
Highlights
The interaction of fiscal and monetary policy is a major issue in macroeconomic theory (e.g., Leeper [1]; Woodford [2]; Canzoneri, Cumby, and Diba [3]), but still under-explored in open-economy environments
The central contributions of this paper are to present a theoretical investigation on the dynamic effects of fiscal and monetary feedback policy rules in a small open economy with flexible exchange rates—whereby external debt is subject to credit risk, consistently with empirical evidence (e.g., Montiel [4])—and point out new analytical results that would not appear in closed-economy frameworks
This result is in contrast with traditional closed-economy environments, in which uniqueness and stability of equilibrium require locally Ricardian fiscal policies in conjunction with interest rate policies overreacting to inflation
Summary
The interaction of fiscal and monetary policy is a major issue in macroeconomic theory (e.g., Leeper [1]; Woodford [2]; Canzoneri, Cumby, and Diba [3]), but still under-explored in open-economy environments. We show that fiscal revaluation mechanisms of the type predicted by the fiscal theory of the price level (see Leeper and Yun [5])—involving endogenous inflation jumps that stabilize in equilibrium real government liabilities—cannot take place because they are ruled out by international parity conditions precluding arbitrage opportunities. It emerges that locally non-Ricardian fiscal policies are destabilizing even under an accommodating monetary policy stance.
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