This paper explores the implications of a new theory of price determination (due to Leeper, Woodford and Sims) for the maintenance of various exchange rate systems – crawling pegs, fixed pegs, and common currency areas. It shows that deeper monetary integration requires more fiscal discipline, especially if price stability is an objective; these monetary arrangements cannot be achieved by monetary policy alone, as conventional wisdom would seem to suggest. A particularly striking result is that a currency peg is simply not sustainable if fiscal surpluses are determined by an exogenous political process; maintenance of a fixed currency peg requires the government to guarantee fiscal solvency for any equilibrium sequence of prices (which Woodford calls a Ricardian Regime). Interestingly, the debt and deficit constraints that were written into the Maastricht Treaty, and will continue in the Stability Pact after EMU, are examples of the fiscal discipline that is required.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
1899.
Find related papers by JEL classification: E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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Daniel, Betty C, 2001.
"A Fiscal Theory of Currency Crises,"
International Economic Review,
Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(4), pages 969-88, November.