FISCAL-POLICY AND THE REAL EXCHANGE-RATE UNDER RISK

This paper examines the effect of fiscal expansions on the real exchange rate in a small open economy, where home and foreign assets are imperfect substitutes. There is an hypothesis, raised by Sachs and Wyplosz (1984), Dornbusch and Fischer (1986), and others, that risk and imperfect substitutability of assets can explain why fiscal expansions sometimes create real depreciations, unlike the standard Mundell-Fleming result. This paper examines the issue within an optimizing framework, where risk and imperfect capital mobility are explicitly modeled. The paper comes up with the conclusion that even when assets are imperfect substitutes, and a fiscal expansion crowds out investment and consumption, this crowding out is not full and the real exchange rate always appreciates. © 1991.