Foreign Currency Denominated Debt and the Fiscal Multiplier

Abstract

This paper aims to explain why fiscal multipliers are generally low, even close to zero, in emerging economies (EMEs). Our explanation jointly relies on the behavior of the exchange rate following a fiscal shock and on the proportion of external debt denominated in foreign currency, which is usually important in EMEs. According to the recent literature, the real exchange rate can depreciate following an increase in public spending. If this is the case, the debt burden denominated in foreign currency increases, and the domestic firms’ balance sheets deteriorate, raising their external finance premium and further crowding out private investment. Finally, this phenomenon may offset the initial crowding-in impact of the public spending shock. We demonstrate that such an explanation is theoretically valid: the higher the share of external debt denominated in foreign currency is, the lower the fiscal multiplier.