Floating or fixed exchange rates: The role of government size

Wegmüller, Philipp (February 2016). Floating or fixed exchange rates: The role of government size (Discussion Papers 14-04). Bern: Department of Economics

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This paper contributes to the ongoing debate on the reform of the international monetary system by evaluating the net welfare gains of monetary policies with flexible exchange rates over a fixed exchange rate as a function of a country’s public sector size. The argument goes back to Anna Schwartz (2000), who linked the role of government size to the viability of a fixed exchange rate regime, as a response to reform plans of the international monetary system by the Bretton Woods Commission (1994). Using a standard New Keynesian small open economy model to quantify this conjecture, three main results emerge: (1) The net welfare gains are increasing in government size; (2) The optimal
simple Taylor rule attains a non-negligible role to stabilizing fluctuations in the nominal
exchange rate; (3) Increasing public sector size reduces output variability irrespective of
the exchange rate policy.

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