Foreign Exchange Risk Premium: Does Fiscal Policy Matter? Evidence from Italian Data

by Lorenzo Giorgianni

Economists and policymakers have long been interested in the effects of fiscal policies on the foreign exchange value of national currencies. Despite this long-standing interest, a recent study of the International Monetary Fund (1995), surveying the available evidence on this matter, notes the absence of clear predictions of the effects of fiscal policy on exchange rates. Both in that research and from anecdotal evidence, however, the view that for countries with large fiscal imbalances, like Belgium, Italy or Sweden, fiscal policy may affect exchange rates through a "risk premium channel" is strongly advocated. According to this view, a credible fiscal contraction in a country with a large stock of public debt, may produce two first, it reduces the amount of government debt held by domestic and foreign investors and, second, it lowers uncertainty about future taxation and debt management policies, which render the domestic economy less vulnerable to external shocks. In a world populated by risk averse investors, both effects would produce an increase in the demand for home-currency denominated assets, thereby, easing or overturning the depreciating pressure on the domestic currency triggered by the initial fiscal contraction and arising from lower domestic interest rates.

40 pages, Kindle Edition

First published April 1, 1997