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Welfare effects of fiscal policy under alternative exchange rate regimes: the role of the scale variable of money demand

Pitterle, Ingo A. and Steffen, Dirk (2004): Welfare effects of fiscal policy under alternative exchange rate regimes: the role of the scale variable of money demand.

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Abstract

This paper investigates the implications of alternative scale variables of money demand for the comparison of a flexible exchange rate regime with a monetary union in a New Open Economy Macroeconomics setup. The welfare evaluation of exchange rate regimes essentially depends on the exchange rate response under the flexible regime. When the scale variable is private consumption, a domestic fiscal expansion yields a depreciation of the domestic currency. The combined expenditure switching and terms-of-trade effects are beneficial to domestic households, who thus prefer a flexible exchange rate regime. However, when the scale variable is total absorption, the domestic currency appreciates and the welfare results are reversed.

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