Fiscal consolidation under fixed exchange rates

We present the 'fixed exchange rate' version of the Obstfeld and Rogoff model and analyze the international transmission of fiscal policy shocks. The welfare effects of an unanticipated contraction in government expenditure in the home country are shown to depend crucially on the way in which world money stock is set. If home authorities alone are responsible for pegging the exchange rate, a fiscal adjustment leads to a decrease in the real interest rate, stimulates private consumption and limits the contraction in world output, compared with a situation in which a cooperative scheme is implemented. The model is then used to propose a new interpretation of recent events in the EU countries that have enacted restrictive fiscal policies while pegging their currencies to the DM. (C) 2001 Elsevier Science B.V. All rights reserved. JEL classification: F41; E63; E65.