The Real Exchange Rate, National Income and the Efficacy of Macropolicy

Abstract

This paper yields new results about the effectiveness of fiscal and monetary policy under both fixed and floating exchange rate regimes. Contrary to accepted theory, yet consistent with recent empirical evidence, it predicts that fiscal consolidation in the form of reduced public consumption strengthens the nominal exchange rate and national income. Alternatively, fiscal expansion in the form of productivity enhancing infrastructure spending can generate current account deficits and appreciate the exchange rate while raising national income. It also shows that exchange rate choice becomes less pivotal in determining the impact of fiscal and monetary policies the more immediate is exchange rate passthrough to the domestic price level.