research.<sup>4</sup> However, there is a compelling case that fiscal policy is hampered in very open economies as a significant part of any boost is bound to leak abroad in the form of imports. This risk is magnified in countries where the exchange rate freely floats if a fiscal expansion triggers an appreciation.<sup>5</sup> Despite these misgivings, it is the only conventional macroeconomic instrument left and it should be used wherever governments can borrow substantial amounts.

The optimal world distribution of fiscal policy effort should recognize the room for maneuver (pre-existing debt, ability to borrow, administrative capacity). While we know far too little about the impact of fiscal policies on exchange rate changes, the safe conclusion is that exchange rates should be stabilized. Put different, if we are going to rely mostly on fiscal policies, hopefully coordinated, the exchange rate should be a playing field as neutral as is possible. Countries that can undertake such policies, with positive externalities for those that cannot, should be protected from potentially offsetting appreciations likely to deter policy action in the first place.

# **3. Country-level incentives**

With policy rates approaching the zero lower bound and budget deficits soaring, policy options become severely constrained. Additionally, policies like fiscal expansion have to be paid at a national level, while their benefits can dilute away to other nations, which makes more direct measures attractive. Many developed and emerging markets have been hit hard by dropping export revenues as a result of the global contraction and falling prices for major export products. To ease the domestic adjustment burden, several countries have an incentive to manage their exchange rate in such a manner that their economies remain competitive. This appears to come at no cost and promises to have a direct impact. However, such a step puts other nations at a disadvantage and imposes on them a disproportionally higher adjustment burden. The consequence is that the behavior of few countries could be contagious.

The likelihood of engaging in exchange rate depreciation policies can be seen as a function of the associated cost and benefits, the range of alternative options to choose from and political will to engage in actions perceived as beggar-thy-neighbour. The benefits should be increasing in both, the importance of the external trade balance for total output and the elasticity of the trade balance to exchange rate changes. The costs are increasing in the level of foreign currency indebtness and the threat of rising inflation.

The alternative options that are available will also play a key role in defining whether policy makers will embark on direct exchange rate intervention or not. Within the group of the major export nations, some countries are already heavily constrained in the extent to which they can choose from various macroeconomic policy options. Countries which: (1) are close to the zero lower bound interest rate loose the classical monetary policy channel (2) have a very high public debt ratio may not want to increase future debt burdens even more, making fiscal expansion less likely (3) expect low inflation rates are more likely to increase the monetary mass since the output

> 4 As recently observed by Yung Chul Park, the IMF’s _World Economic Outlook_ concludes in its October 2008 issue that fiscal policy is largely ineffective while it finds it effective in its April 2009 version.

> 5 The Mundell-Fleming model predicts a 100% offset that makes fiscal policy wholly ineffective.

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