Fiscal regimes and the exchange rate

BIS Working Papers  |  No 950  | 
10 June 2021



We study how the exchange rate's response to monetary and fiscal policy depends on the fiscal regime. In a Ricardian regime, the government always backs its debt, ie commits to increasing taxes in the future to satisfy its intertemporal budget constraint. In a non-Ricardian regime, the government does not necessarily commit to finance its debt. In this case, the fiscal authority may eventually default or the central bank may accommodate fiscal deficits, creating money and inflating away the debt.


We use the daily forecasts of the primary balance and the monetary policy rate around policy announcements to construct a time series of fiscal and monetary policy surprises. We look at daily movements of the Brazilian real around policy announcements and test whether its reaction is different during periods of fiscal distress. We develop a small open economy model of sovereign default in which the fiscal regime switches between Ricardian and non-Ricardian, and sovereign risk drives the currency excess return.


In normal times, an increase in the Brazilian policy rate or in government spending leads to an appreciation of the real. During periods of fiscal distress, when market participants' concern about debt sustainability rises, the real depreciates. The model replicates these findings. A higher interest rate or fiscal deficit leads to an appreciation of the currency when the fiscal regime is Ricardian. When the regime is non-Ricardian, the associated increase in debt raises sovereign risk and the currency excess return, depreciating the exchange rate. The unconventional behaviour of the exchange rate in the non-Ricardian regime persists if the central bank accommodates the fiscal deficit through higher inflation.


In this paper, we argue that the effect of monetary and fiscal policies on the exchange rate depends on the fiscal regime. A contractionary monetary (expansionary fiscal) shock can lead to a depreciation, rather than an appreciation, of the domestic currency if debt is not backed by future fiscal surpluses. We look at daily movements of the Brazilian real around policy announcements and find strong support for the existence of two regimes with opposite signs. The unconventional response of the exchange rate occurs when fiscal fundamentals are deteriorating and markets' concern about debt sustainability is rising. To rationalize these findings, we propose a model of sovereign default in which foreign investors are subject to higher haircuts and fiscal policy shifts between Ricardian and non-Ricardian regimes. In the latter, sovereign default risk drives the currency risk premium and affects how the exchange rate reacts to policy shocks.

JEL classification: E52, E62, E63, F31, F34, F41, G15

Keywords: exchange rate, monetary policy, fiscal policy, fiscal dominance, sovereign default