Using Fiscal Policy to Target the Exchange Rate

This paper proposes an approach to macroeconomic policy which equips the authorities in small, open, financially-integrated economies (SOFIEs) to target the exchange rate by influencing the volumes of trade in goods and services to achieve equilibrium at the target rate. This is achieved by the use of fiscal policy: the authorities may adjust the size of the fiscal deficit and how it is financed to contain the level of aggregate expenditure in the economy, and the demand for imports that flows from that expenditure. In the longer term, productivity-enhancing measures will secure growth in the supply of foreign exchange. The exchange rate anchor keeps domestic inflation in line with world price changes. Moreover, the anchor is a powerful indicator of economic policy success and a persuasive reason to adopt necessary adjustment. A country which is able to set an exchange rate target and achieve it consistently over time gains credibility for its overall economic strategy. In the open economy the impact of depreciating exchange rates on the purchasing power of incomes is considerable, and erodes the savings habit. Exchange rate volatility discourages investment and may cause financial instability