Fiscal Theory, Price Level, and Exchange Rate

Abstract

Government surplus forecasts comove strongly with nominal and real exchange rates. They are the best explanatory variable of exchange rate movements at semi-annual frequency in my post-2008 sample. In comparison, the comovement between government surplus forecasts and price level movements is much weaker. I develop a model to show how price stickiness can reconcile these findings. Because prices are sticky while exchange rates are flexible, nominal and real exchange rates adjust in response to fiscal shocks. This model connects exchange rates to the fiscal side of economic fundamentals, and provides a more realistic fiscal theory of currency value.

Keywords: Exchange Rate, Fiscal Theory of Price Level, Sticky Prices

JEL Classification: F31