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Fiscal Policy and Welfare under Different Exchange Rate Regimes

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The article analyses how government spending is determined under differentexchange rate regimes in the context of a small open economy. Assumingnominal wage contracts which last for one period and assuming a benevolentgovernment which determines government spending to optimise a representativeindividual’s utility, it is demonstrated that there are differences betweenexchange rate regimes with respect to the level of government spending. Thesedifferences arise first because a rise in government spending affects macroeconomicvariables differently under different exchange rate regimes, and secondbecause the government’s inclination to expand government spending is affectedby inflation which depends on the exchange rate regime. At low rates of inflation,the government is inclined to set a higher level of government spending under afixed exchange rate regime than under a floating exchange rate regime in whichthe monetary authority optimises preferences which include an employment targetand an inflation target. As government spending affects the representativeindividual’s utility, the choice of exchange rate regime has an impact on welfare.Keywords: exchange rate regimes; fiscal policy; monetary union; inflationtargeting.JEL classicification: E42, E61, E62, F33.

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Finn Østrup

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