ABSTRACT
INTRODUCTION How would a bond-financed fiscal expansion affect the exchange rate in a floating rate regime? The answer seems obvious in the Mundell-Fleming model, which is the standard model used in textbooks. With high international capital mobility there must be an appreciation, unless the money supply is expanded sufficiently. On the other hand, with low capital mobility, depreciation will result. Then there is the portfolio balance model which gives an ambiguous answer. In addition we have the various models that focus on the relationship between the real exchange rate and the current account, the models with an intertemporal budget constraint, the ‘unpleasant monetarist arithmetic’ model, and finally, models which focus on expectations and their determination. Indeed, one’s reaction might be that exchange rates in a floating rate regime depend primarily on expectations, and these are impossible to predict and hard to explain rationally after the event.
