Fiscal Regimes and the Exchange Rate
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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