FISCAL-POLICY AND THE REAL EXCHANGE-RATE

This paper reconsiders some conventional notions about fiscal policy under flexible exchange rates using an extended version of the Dornbusch 'overshooting' model; the extension allows for a long-run link between output and the real exchange rate. Unanticipated permanent fiscal policy affects both current and long-run output; while the long-run effect is always in the expected direction, it is possible that the current effect is perverse. Both fiscal and monetary policy must cause either nominal exchange rate overshooting or perverse domestic interest rate effects. The results suggest that real shocks are a potential source of high exchange rate variability. © 1990.