Fiscal Policy, Portfolio Frictions, and International Transmission

The paper documents a strong empirical relationship between government debt, the real exchange rate (RER), and net exports in the United States.

Periods of high government debt are consistently associated with a depreciated RER and subsequent increases in net exports.

Causal evidence from debt-financed fiscal expansions shows transmission primarily through deviations from uncovered interest parity (UIP), leading to a depreciated RER and increased net exports over time.

These shocks explain around 20 percent of the variance in US government debt, the RER, and net exports, making them significant drivers.

The study finds that US government spending shocks induce non-monotonic UIP dynamics, with US government bonds earning an excess return over Rest of the World (ROW) bonds in the medium and long run.

Furthermore, US agents increase their holdings of foreign assets after a positive spending shock, responses that contradict frictionless models and suggest financial market imperfections.

The proposed model, featuring portfolio rebalancing frictions, explains this empirical evidence and generates dynamics consistent with the RER disconnect.

Standard open-economy models struggle to reconcile fiscal expansions with real exchange rate (RER) depreciations and net export improvements.

This difficulty has often led the literature to rely on reduced-form shocks with limited direct empirical evidence.

This paper addresses these challenges by developing a two-country general equilibrium model.

Key features include a fiscal rule heavily reliant on government debt to finance spending and portfolio rebalancing frictions.

These frictions are modeled as a convex cost of deviating from the long-run portfolio share of foreign assets, capturing factors like risk, liquidity, or behavioral biases that limit portfolio rebalancing.

The interaction between the fiscal rule and these frictions determines the international transmission of US government spending shocks, offering a tractable way to explain the observed dynamics.