Fiscal stabilization and exchange rate instability. A theoretical approach and some policy conclusions using Mexican data

We construct a perfect foresight intertemporal general equilibrium model designed to analyze the impact of reductions in piblic spending. The model incorporates public infrastructure that enters private productions and a reserve-based government exchange rate policy. The model is estimated for Mexico and a three-year benchmark equilibrium is computed. Counterfactual simulations are carried out, with one of the conclusions being that a reduction in government spending can be inflationary. The results are sensitive to the elasticity of private output with respect to government infrastructure.