Public spending, currency mismatch and financial frictions

• Published in: Journal of international money and finance 2021-09, Vol.116, p.102413, Article 102413
• Main Authors: Hory, Marie-Pierre, Levieuge, Grégory, Onori, Daria
• Format: Article
• Language: English
• Subjects: Currency mismatch; DSGE model; Economics and Finance; Financial frictions; Fiscal multiplier; Humanities and Social Sciences; Terms of trade
• ISSN: 0261-5606; 1873-0639
• DOI: 10.1016/j.jimonfin.2021.102413

•The size of the fiscal multiplier depends both on currency mismatch and home bias.•The terms of trade improve following a fiscal stimulus if home bias is high.•So the higher the debt in foreign currency, the higher the fiscal multiplier.•In contrast, the terms of trade deteriorate when home bias is low.•In this case, the higher the debt in foreign currency, the lower the multiplier. In this paper, we demonstrate that the size of the fiscal multiplier depends both on currency mismatch and home bias. Our demonstration is based on a real two-country dynamic stochastic general equilibrium model with incomplete and imperfect international financial markets, external debt and domestic financial frictions. We show that if home bias is high, the terms of trade improve following a fiscal stimulus. This reduces the private real debt burden denominated in foreign currency, decreases the external finance premium born by firms, and stimulates investment. Thus, the larger the proportion of firms’ debt denominated in foreign currency is, the higher the fiscal multiplier. In contrast, the terms of trade deteriorate when home bias is low. This increases the real debt burden and external finance premium. Hence, in this case, the fiscal multiplier decreases as the share of firms’ debt denominated in foreign currency increases.