© Sanjay K. Chugh
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.
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.
will build a small theoretical model that allows us to study this interaction.
theoretical model will consist of four building blocks:
Money demand function
Purchasing power parity (PPP)
Interest parity condition
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.
By now you are comfortable with the idea of the two-period economy we used in
studying the representative consumer’s consumption-savings decision.
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.
reasons why we need an arbitrarily large number of time periods will become clearer as
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
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