Fiscal policy and exchange rates

This paper examines the dynamics of the nominal exchange rate and fiscal deficits in a continuous time optimising general equilibrium model with finite horizon. It is shown that alternative financing modes of budget deficits imply different patterns of adjustment along the transitional path towards the steady state equilibrium. Fiscal policy may provide the nominal anchor for the exchange rate and the respect of public solvency without money financing is not sufficient to avoid the depreciation of the exchange rate in the long-run after a fiscal expansion.