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Fiscal Policy and Stabilization of Exchange Rates under Alternative Criteria.

  • Economics


This paper examines the role of fiscal policy in the determination of the exchange rate in a small open economy and discusses the efficiency of feedback rule s in minimizing the volatility of the exchange rate. Two criteria are introduced to stabilize the large fluctuations in exchange rates: (1 ) minimizing the variance of the exchange rate and (2) minimizing the expected squared gap between the full and incomplete current informa tion values of the exchange rate. The two criteria are based on diffe rent beliefs regarding the working of the market forces and require t he choice of diametrically opposed policy rules.

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