External Debt and Stabilizing Macroeconomic Policies

Abstract

This paper investigates the dynamic effects of fiscal and monetary feedback policy rules in a small open economy with flexible exchange rates and risk premia on external debt. It is shown that equilibrium uniqueness and stability occur under locally Ricardian fiscal policies regardless of the degree of reaction of nominal interest rates to inflation, in contrast with closed-economy environments. Fiscal revaluation mechanisms of the type predicted by the fiscal theory of the price level are precluded by international parity conditions. As a result, locally non-Ricardian fiscal policies are destabilizing even under an accommodating monetary policy stance.