Fiscal regimes and the exchange rate

Enrique Alberola-Ila, Carlos Cantú, Paolo Cavallino and Nikola Mirkov in this BIS paper:

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.

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