Spillover Effects of Fiscal Policy Under Flexible Exchange Rates

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 economy macroeconomics (NOEM) approach. 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. Therefore, government expenditures are relevant for overall money demand. Providing closed form solutions, we find that a balanced budget fiscal expansion results in an appreciation of the exchange rate. This result stands in sharp contrast to standard open economy models with money-in-the-utility (MIU), that predict depreciations. The exchange rate movement is all the more pronounced, the higher the degree of pricing-to-market (PTM) 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 temporarily shortened. Therefore, the deterioration of the trade balance is exacerbated when compared with MIU models. We show that the terms of trade depend qualitatively and quantitatively on the degree of PTM, whereas a home bias in consumption only rules its amplitude. A rigorous welfare analysis reveals that a fiscal expansion is a prosper-thy-neighbor instrument. A higher share of PTM goods reinforces the prosper-thy-neighbor effect while a home bias in consumption tends to reduce the positive spillover effects.