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FISCAL STABILIZATION WITH PARTIAL EXCHANGE RATE PASS-THROUGH

Authors

  • ERASMUS K. KERSTING

    1. Kersting: Department of Economics, Villanova University, Villanova, PA 19085. Phone 610-519-4342, Fax 610 519 6054, E-mail erasmus.kersting@villanova.edu
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    • A previous version of this article has been circulated under the title “Policy Coordination, Fiscal Stabilization and Endogenous Unions.” I would like to thank my thesis advisor Dennis Jansen. In addition, comments and suggestions by Leonardo Auernheimer, Russell Cooper, Scott Dressler, Enrique Martinez-Garcia, Erwan Quintin, Geneviève Verdier, Mark Wynne, and two anonymous referees have been helpful and were greatly appreciated.


Abstract

This article examines the role of fiscal stabilization policy in a two-country framework that allows for partial exchange rate pass-through. Analytical solutions for optimal monetary and fiscal policy rules depend on the degree of pass-through. Each country unilaterally uses its fiscal instrument to stabilize the costs facing exporters. The welfare effects differ strongly depending on the degree of pass-through. For high levels, both countries are better off with the fiscal instrument and welfare is closer to the benchmark flex-price level. For low levels, however, the unilateral equilibrium policy rules lead to high volatility in taxes, and fiscal policy ends up being destabilizing by transmitting exchange rate fluctuations. Because these results stem from strategic considerations by the two countries, the fiscal instrument is not used under policy coordination. In addition, imposing a monetary union increases welfare when pass-through is low, including the case of local currency pricing. (JEL E52, E63, F41, F42)

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