Journal Article

Accounting for the Effects of Fiscal Policy Shocks on Exchange Rates through Markup Dynamics

Abstract: This study investigates how fiscal policy shocks affect the external sector through markup dynamics in advanced and developing economies. We focus on the role of markup dynamics as a channel through which fiscal policy has a distinct effect on real exchange rates. Using panel data from 32 countries, we employ a local projection to evaluate the impact of expansionary fiscal policy shocks on real exchange rates, markups, and current accounts. Our empirical findings show distinct responses to the shocks among advanced and developing countries regarding the real exchange rate, due to different markup dynamics. Expansionary fiscal measures result in an appreciation of the real exchange rate and an increase in markup for developing countries, whereas advanced economies experience a decrease in markup and a depreciation of the real exchange rate. Markup dynamics vary between advanced and developing economies due to differences in firms' entry and exit conditions in their institutions. In advanced economies, expansionary fiscal policy shocks promote competition and new firm entry, resulting in a reduced markup. On the other hand, unfavorable conditions in developing countries maintain or increase existing firms' market power. Our research highlights the heterogeneous effects of fiscal policy shocks on the external sector, emphasizing the need for policymakers to consider institutional and entry conditions while designing and implementing fiscal policies.

Keywords: fiscal policy; fiscal policy shocks; markup dynamics; real exchange rates;

JEL Classification: F41; H32; L11;

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Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Review

Publication Date: 2024-04-15

Volume: 106

Issue: 2

Pages: 129-145