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A Fiscal Theory of Currency Crises

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Author Info
Betty Daniel (University of Albany)

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Abstract

This paper presents a fiscal theory of exchange rate crises. When the fiscal authority allows the present value of primary surpluses inclusive of seigniorage to differ from the current real value of government debt at the pegged exchange rate and a constant expected future interest rate, then the pegged rate is no longer viable. According to the fiscal theory of the price level, the current exchange rate (equivalently the price level) and the price of long-term government bonds, must equate the real value of government debt and the present value of primary surpluses. In the absence of long-term government bonds, the exchange rate must do the job, and collapse is instantaneous with the change in the present value of primary surpluses. In the presence of a sufficient quantity of long-term bonds, the price of long-term bonds can adjust the real value of government debt, and the collapse can be delayed. Whether collapse is instantaneous or delayed is at the discretion of the monetary authority. The paper shows that while fiscal policy is responsible for generating the crisis, monetary policy is responsible for its characteristics. These include the timing of the crisis and the magnitude of the collapse- period depreciation. This is a fundamentals theory of exchange rate crises. However, the theory shifts the focus for the cause of collapse away from monetary policy toward fiscal policy. And it demonstrates that fundamentals-generated collapse need not occur following a sustained period of policy misalignment and reserve loss. It can explain other types of exchange rate crises, including those, which surprise markets, as with the ERM crises in 1993, and crises caused by expectations of future fiscal expenditures with no sustained reserve loss, as in the Southeast Asian crises of 1997.

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Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 0535.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:0535

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  3. John H. Cochrane, 1998. "A Frictionless View of U.S. Inflation," NBER Working Papers 6646, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, vol. 4(3), pages 381-99.
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  10. Jeffrey Sachs & Aaron Tornell & Andres Velasco, 1996. "The Mexican Peso Crisis: Sudden Death or Death Foretold?," NBER Working Papers 5563, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Garber, Peter M. & Svensson, Lars E.O., 1995. "The operation and collapse of fixed exchange rate regimes," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 36, pages 1865-1911 Elsevier. [Downloadable!] (restricted)
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  12. Canzoneri, Matthew B & Cumby, Robert & Diba, Behzad, 1998. "Fiscal Discipline and Exchange Rate Regimes," CEPR Discussion Papers 1899, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  14. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  15. Michael Woodford, 1995. "Price Level Determinacy Without Control of a Monetary Aggregate," NBER Working Papers 5204, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Burnside, C. & Eichenbaum, M. & Rebelo, S., 1998. "Prospective Deficits and the Asian Currency Crisis," RCER Working Papers 458, University of Rochester - Center for Economic Research (RCER).
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  17. Auernheimer, Leonardo, 1987. "On the outcome of inconsistent programs under exchange rate and monetary rules : Allowing the market to compensate for government mistakes," Journal of Monetary Economics, Elsevier, vol. 19(2), pages 279-305, March. [Downloadable!] (restricted)
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  19. Buiter, Willem H, 1989. "A Viable Gold Standard Requires Flexible Monetary and Fiscal Policy," Review of Economic Studies, Blackwell Publishing, vol. 56(1), pages 101-17, January. [Downloadable!] (restricted)
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  20. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August. [Downloadable!] (restricted)
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  22. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, vol. 4(3), pages 345-80.
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  27. Barry Eichengreen & Charles Wyplosz, 1993. "The Unstable EMS," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(1993-1), pages 51-144. [Downloadable!]
  28. Maurice Obstfeld, 1986. "Speculative Attack and the External Constraint in a Maximizing Model of the Balance of Payments," NBER Working Papers 1437, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  29. Flood, Robert P. & Marion, Nancy P., 2000. "Self-fulfilling risk predictions:: an application to speculative attacks," Journal of International Economics, Elsevier, vol. 50(1), pages 245-268, February. [Downloadable!] (restricted)
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  30. Drazen, Allan, 1985. "Tight money and inflation: Further Results," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 113-120, January. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Cruz Rodriguez, Alexis, 2009. "Choosing and assessing exchange rate regimes: A survey of the literature," MPRA Paper 16314, University Library of Munich, Germany. [Downloadable!]
  2. Aloy, Marcel & Moreno-Dodson, Blanca & Nancy, Gilles, 2008. "Intertemporal adjustment and fiscal policy under a fixed exchange rate regime," Policy Research Working Paper Series 4607, The World Bank. [Downloadable!]
  3. Craig Burnside, 2004. "The Research Agenda: Craig Burnside on the Causes and Consequences of Twin Banking-Currency Crises," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 5(2), April. [Downloadable!]
  4. Barbara Annicchiarico, 2006. "Fiscal Policy and Exchange Rates," Journal of Economics, Springer, vol. 89(2), pages 165-185, November. [Downloadable!] (restricted)
    Other versions:
  5. David B. Gordon & Eric M. Leeper, 2002. "The Price Level, the Quantity Theory of Money, and the Fiscal Theory of the Price Level," NBER Working Papers 9084, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  6. Michael Kumhof & Ricardo Nunes & Irina Yakadina, 2008. "Simple monetary rules under fiscal dominance," International Finance Discussion Papers 937, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
  7. Bartosz Mackowiak, 2006. "Macroeconomic Regime Switches and Speculative Attacks," SFB 649 Discussion Papers SFB649DP2006-025, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
    Other versions:
  8. Barbara Annicchiarico, 2002. "Fiscal Policy And Exchange Rates," Departmental Working Papers 174, Tor Vergata University, CEIS. [Downloadable!]
  9. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 2003. "Government Finance in the Wake of Currency Crises," RCER Working Papers 501, University of Rochester - Center for Economic Research (RCER). [Downloadable!]
    Other versions:
  10. Michael Woodford, 2001. "Fiscal Requirements for Price Stability," NBER Working Papers 8072, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  11. Flood, Robert P & Jeanne, Olivier, 2000. "An Interest Rate Defence of a Fixed Exchange Rate?," CEPR Discussion Papers 2507, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  12. Järvinen, Marketta, 2002. "Exchange rate regimes and nominal convergence in the CEECs," BOFIT Discussion Papers 4/2002, Bank of Finland, Institute for Economies in Transition. [Downloadable!]
  13. Andre, Nyembwe, 2003. "Monetary Policy, Credibility and Asymmetries : Small African Countries and the EMU Advent," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) 2003011, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES), revised 06 Aug 2002. [Downloadable!]
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