The fiscal multiplier when debt is denominated in foreign currency

Abstract

In this paper, we show that the proportion of private debt denominated in foreign currency can be a determinant of the size of the domestic fiscal multiplier. The demonstration relies on a two-country New Keynesian DSGE model with nominal rigidities and financial frictions. In line with recent evidence, the model can reproduce the depreciation of the domestic currency following an increase in public spending. We show that, in this case, the increase in debt burden denominated in foreign currency deteriorates the domestic firms’ balance sheets. This raises their external finance premium and crowds out private investment, ultimately offsetting the stimulative effect of the government spending shock.