Chapter16 - Chapter 16 Fiscal Theory of Exchange Rates We...

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© Sanjay K. Chugh 195 Spring 2008 Chapter 16 Fiscal Theory of Exchange Rates We now turn to the subject of international monetary economics. Specifically, we will consider the interaction of a fixed exchange rate system with fiscal policy. Exchange rate management is typically thought to be in the domain of monetary, not fiscal, policy. However, we will learn that fiscal policy considerations also impact exchange rates. We will build a small theoretical model that allows us to study this interaction. Our theoretical model will consist of four building blocks: 1. Money demand function 2. Purchasing power parity (PPP) 3. Interest parity condition 4. Government budget constraint Before we describe these four building blocks, we first discuss the timing of the model. Specifically, rather than a two-period economy we have considered in much of our study, we will consider an infinite-period economy. Then, after laying out the four building blocks, we consider the workings of the model, paying close attention to the influence of fiscal policy on nominal exchange rates. Infinite-Period Economy By now you are comfortable with the idea of the two-period economy we used in studying the representative consumer’s consumption-savings decision. The two-period economy served our purposes in that task, but turns out to be insufficient in our present study of the interaction between fiscal policy and exchange rates. Thus, we now generalize our model economy to allow for an infinite number of time periods. The reasons why we need an arbitrarily large number of time periods will become clearer as we proceed. In the two-period economy, the “names” of each of the two periods was fairly natural – we named them period 1 and period 2. We could analogously name the time periods in our present infinite-period economy as period 1, period 2, period 3, period 4, period 5, etc, without end. However, again as will become clearer below, the specific “name” of a given time period will have no relevance – all that will matter is how far (in time) a given time period is from any other given time period and whether it comes before or after it. For example, period 2 is two time periods earlier than period 4. But period 11 is also two time periods earlier than period 13. And period 134 is two time periods earlier than time period 136. Because all we will need to care about is how time periods relate to each other, rather than any absolute sense of time, we will name the time periods in a more general fashion, specifically by calling them t , 1 t ± , 2 t ± , 3 t ± , 4 t ± , … With this
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© Sanjay K. Chugh 196 Spring 2008 notation, t can take on any value: we could have 0 t , in which case 1 1 t ± and 2 2 t ± . Or we could have 11 t , in which case 1 12 t ± and 2 13 t ± . And so forth.
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