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Fiscal Discipline and Exchange Rate Regimes

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  • Rupa Duttagupta
  • Guillermo Tolosa
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    Abstract

    This paper assesses the nature of fiscal discipline under alternative exchange rate regimes. First, it shows in a simple theoretical framework that fiscal agencies under a currency union with a fixed exchange rate can have the largest incentive to overspend or "free-ride" (compared to those under other exchange rate regimes) owing to their ability to spread the costs of overspending in terms of the inflation tax across both time-given the fixed exchange rate-and space-given the currency union. In contrast, such free-riding behavior does not arise under flexible regimes owing to the immediate inflationary impact of spending. Next, empirically, it shows that fiscal stances in countries with fixed pegs and currency unions regime demonstrate greater free-riding behavior than countries with more flexible regimes in 15 Caribbean countries during 1983-2004.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/119.

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    Length: 37
    Date of creation: 01 May 2006
    Date of revision:
    Handle: RePEc:imf:imfwpa:06/119

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    Related research

    Keywords: Fiscal policy; Exchange rates; Exchange rate regimes; Flexible exchange rates; Currency pegs; exchange rate; fiscal stances; fixed exchange rate; fiscal policies; fiscal discipline; fiscal stance; government spending; fixed exchange rates; exchange rate regime; alternative exchange rate; alternative exchange rate regimes; fiscal incentives; currency unions; budget constraint; fiscal authorities; flexible exchange rate; fiscal performance; fiscal deficits; primary expenditure; fiscal expansion; fiscal agencies; public debt; fixed exchange rate regimes; fixed exchange rate regime; fiscal balances; fiscal revenue; government budget; flexible exchange rate regime; exchange rate arrangements; fiscal behavior; fiscal spending; fiscal revenues; government budget constraint; fiscal profligacy; budget constraints; fiscal outcomes; fiscal balance; flexible exchange rate regimes; fiscal solvency; exchange restrictions; fiscal effort; exchange arrangements; fiscal indiscipline; fixed ? exchange rate; flexible ? exchange rates; floating exchange rate regime; social expenditure; government budget constraints; fiscal imbalances; expansionary fiscal policy; nominal exchange rate; fiscal constraint; fiscal expenditure; intergovernmental fiscal relations; primary fiscal balance; fiscal rules; fiscal efforts; public deficits; fiscal expansions; fiscal sustainability; exchange rate policies; fiscal reforms; expansionary fiscal; budget deficits; intergovernmental fiscal; classification of exchange rate; fiscal transparency; government expenditures; current exchange rate; expenditure growth; de facto exchange rate regime; exchange rate system; prevailing exchange rate; fiscal agents; primary deficit; budget process; fiscal relations; exchange rate stability; floating exchange rate; fiscal constraints;

    References

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    1. Anthony J. Pellechio & Saqib Rizavi & Phebby Kufa, 2003. "Fiscal Sustainability and Policy Issues in the Eastern Caribbean Currency Union," IMF Working Papers 03/162, International Monetary Fund.
    2. Yan Sun, 2003. "Do Fixed Exchange Rates Induce More Fiscal Discipline?," IMF Working Papers 03/78, International Monetary Fund.
    3. Graciela L. Kaminsky & Carmen M. Reinhart & Carlos A. Végh, 2005. "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 11-82 National Bureau of Economic Research, Inc.
    4. Alberto Alesina & Ricardo Hausmann & Rudolf Hommes & Ernesto Stein, 1996. "Budget Institutions and Fiscal Performance in Latin America," NBER Working Papers 5586, National Bureau of Economic Research, Inc.
    5. Beetsma, R.M.W.J. & Bovenberg, A.L., 1995. "Does Monetary Unification Lead to Excessive Debt Accumulation?," DELTA Working Papers 95-23, DELTA (Ecole normale supérieure).
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    7. Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
    8. Carmen M. Reinhart, 2002. "Default, Currency Crises, and Sovereign Credit Ratings," World Bank Economic Review, World Bank Group, vol. 16(2), pages 151-170, August.
    9. Guillermo A. Calvo & Frederic S. Mishkin, 2003. "The Mirage of Exchange Rate Regimes for Emerging Market Countries," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 99-118, Fall.
    10. Aaron Tornell & Andres Velasco, 1995. "Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?," NBER Working Papers 5108, National Bureau of Economic Research, Inc.
    11. Francesco Giavazzi & Marco Pagano, 1991. "The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 303-330 National Bureau of Economic Research, Inc.
    12. Chari, V.V. & Kehoe, Patrick J., 2007. "On the need for fiscal constraints in a monetary union," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2399-2408, November.
    13. von Hagen, Jurgen & Harden, Ian J., 1995. "Budget processes and commitment to fiscal discipline," European Economic Review, Elsevier, vol. 39(3-4), pages 771-779, April.
    14. Taimur Baig & Abdul Abiad, 2005. "Underlying Factors Driving Fiscal Effort in Emerging Market Economies," IMF Working Papers 05/106, International Monetary Fund.
    15. Fatás, Antonio & Rose, Andrew K, 2001. "Do Monetary Handcuffs Restrain Leviathan? Fiscal Policy in Extreme Exchange Rate Regimes," CEPR Discussion Papers 2692, C.E.P.R. Discussion Papers.
    16. George Kopits & Helge Berger & István P. Székely, 2004. "Fiscal Indulgence in Central Europe," IMF Working Papers 04/62, International Monetary Fund.
    17. Xavier Debrun, 2000. "Fiscal Rules in a Monetary Union: A Short-Run Analysis," Open Economies Review, Springer, vol. 11(4), pages 323-358, October.
    18. Enrique Alberola & Luis Molina, 2005. "What Does Really Discipline Fiscal Policy In Emerging Markets? The Role And Dynamics Of Exchange Rate Regimes," International Finance 0507003, EconWPA.
    19. Ratna Sahay, 2005. "Stabilization, Debt, and Fiscal Policy in the Caribbean," IMF Working Papers 05/26, International Monetary Fund.
    20. Axel Schimmelpfennig & Nouriel Roubini & Paolo Manasse, 2003. "Predicting Sovereign Debt Crises," IMF Working Papers 03/221, International Monetary Fund.
    21. Woo, Jaejoon, 2003. "Economic, political, and institutional determinants of public deficits," Journal of Public Economics, Elsevier, vol. 87(3-4), pages 387-426, March.
    22. Paul R. Masson & Morris Goldstein & Jacob A. Frenkel, 1991. "Characteristics of a Successful Exchange Rate System," IMF Occasional Papers 82, International Monetary Fund.
    23. Tobias N. Rasmussen, 2004. "Macroeconomic Implications of Natural Disasters in the Caribbean," IMF Working Papers 04/224, International Monetary Fund.
    24. Shang-Jin Wei & Irina Tytell, 2004. "Does Financial Globalization Induce Better Macroeconomic Policies?," IMF Working Papers 04/84, International Monetary Fund.
    25. repec:rus:hseeco:123922 is not listed on IDEAS
    26. Bergin, Paul R., 2000. "Fiscal solvency and price level determination in a monetary union," Journal of Monetary Economics, Elsevier, vol. 45(1), pages 37-53, February.
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    Citations

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    Cited by:
    1. Shaun K. Roache, 2007. "Public Investment and Growth in the Eastern Caribbean," IMF Working Papers 07/124, International Monetary Fund.
    2. Hallerberg, Mark & Wolff, Guntram B., 2006. "Fiscal institutions, fiscal policy and sovereign risk premia," Discussion Paper Series 1: Economic Studies 2006,35, Deutsche Bundesbank, Research Centre.
    3. Rui Ota & Stephanie Medina Cas, 2008. "Big Government, High Debt, and Fiscal Adjustment in Small States," IMF Working Papers 08/39, International Monetary Fund.

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