A Fiscal Theory of Currency Crises

Abstract

An exchange rate crisis is caused when the fiscal authority lets the present value of primary surpluses, inclusive of seigniorage, deviate from the value of government debt at the pegged exchange rate. In the absence of long-term government bonds, the exchange rate collapse must be instantaneous. With longterm government bonds, the collapse can be delayed at the discretion of the monetary authority. Fiscal policy is responsible for the inevitability of a crisis, while monetary policy determines its characteristics, that is, the timing of the crisis and the magnitude of exchange rate depreciation.

External shocks, U.S. monetary policy and macroeconomic fluctuations in emerging markets

“…The government adopts a fixed exchange rate policy, which is a form of active monetary policy. 7 Passive fiscal policy is put in place with the aim of making the fixed exchange rate sustainable. Public debt fluctuates over time due to shocks to revenues and expenditures.…”

Currency crises and contingent liabilities

“…While the answer to this question is not obvious, it may be related to why governments do not accumulate-or are not willing to lose-reserves to avoid crises: issuing nominal debt, like accumulating reserves, is expensive and requires an ex-ante fiscal outlay. 6 With nominal debt, the model becomes consistent with work on the fiscal theory of the price level by Sims (1994), Woodford (1995), Corsetti and Mackowiak (2000), Cochrane (2001), Daniel (2001) and Dupor (2000).…”

Choosing and Assessing Exchange Rate Regimes: A Survey of the Literature

“…Such combinations are exposed to speculative attacks resulting from fundamental policy inconsistencies (Krugman, 1979) or self-fulfilling expectations that arise in the context of multiple equilibriums (Obstfeld, 1996) 19 . Some authors highlight the inconsistency between fiscal policy fundamentals and the exchange rate peg that leads to currency crises (De Kock and Grilli, 1993;Daniel, 1997Daniel, , 2001Corsetti and Mackowiak, 2005, among others). On the other hand, several studies suggest that countries exposed to large capital flows (countries with an open capital account) must avoid unstable exchange rate regimes and are left with two corner solutions: a hard currency peg (such as a currency board, dollarization or monetary union) 20 or pure floating exchange rate regimes.…”