Template-type: ReDIF-Paper 1.0
Author-Name: Enrique Alberola
Author-Name-First: Enrique
Author-Name-Last: Alberola
Author-Name: Carlos Cantú
Author-Name-First: Carlos
Author-Name-Last: Cantú
Author-Name: Paolo Cavallino
Author-Name-First: Paolo
Author-Name-Last: Cavallino
Author-Name: Nikola Mirkov
Author-Name-First: Nikola
Author-Name-Last: Mirkov
Author-Person: pmi597
Title: Fiscal regimes and the exchange rate
Abstract: In this paper, we argue that the effect of monetary and fiscal policies on the exchange rate depends on the fiscal regime. A contractionary monetary (expansionary fiscal) shock can lead to a depreciation, rather than an appreciation, of the domestic currency if debt is not backed by future fiscal surpluses. We look at daily movements of the Brazilian real around policy announcements and find strong support for the existence of two regimes with opposite signs. The unconventional response of the exchange rate occurs when fiscal fundamentals are deteriorating and markets' concern about debt sustainability is rising. To rationalize these findings, we propose a model of sovereign default in which foreign investors are subject to higher haircuts and fiscal policy shifts between Ricardian and non-Ricardian regimes. In the latter, sovereign default risk drives the currency risk premium and affects how the exchange rate reacts to policy shocks.
Length: 59 pages
Creation-Date: 2022
Contact-Email: forschung@snb.ch
File-URL: https://www.snb.ch/en/publications/research/working-papers/2022/working_paper_2022_01
File-Format: text/html
Number: 2022-01
Classification-JEL: E52, E62, E63, F31, F34, F41, G15
Keywords: Exchange rate, monetary policy, fiscal policy, fiscal dominance, sovereign default
Handle: RePEc:snb:snbwpa:2022-01