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Fiscal Discipline and Exchange Rate Regimes: Evidence from the Caribbean

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Author Info
Guillermo Tolosa
Rupa Duttagupta
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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Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/119.

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Length: 37 pages
Date of creation: 12 May 2006
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Handle: RePEc:imf:imfwpa:06/119

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Keywords: Fiscal policy currency unions exchange rates Fiscal policy Caribbean Monetary unions Exchange rate regimes Flexible exchange rates Currency pegs

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This paper has been announced in the following NEP Reports: References listed on IDEAS
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. Tobias N. Rasmussen, 2004. "Macroeconomic Implications of Natural Disasters in the Caribbean," IMF Working Papers 04/224, International Monetary Fund. [Downloadable!]
  2. Graciela L. Kaminsky & Carmen M. Reinhart & Carlos A. Vegh, 2004. "When it Rains, it Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Working Papers 10780, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Alesina, Alberto & Hausmann, Ricardo & Hommes, Rudolf & Stein, Ernesto, 1999. "Budget institutions and fiscal performance in Latin America," Journal of Development Economics, Elsevier, vol. 59(2), pages 253-273, August. [Downloadable!] (restricted)
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  4. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," NBER Working Papers 9908, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Abdul Abiad & Taimur Baig, 2005. "Underlying Factors Driving Fiscal Effort in Emerging Market Economies," IMF Working Papers 05/106, International Monetary Fund. [Downloadable!]
  6. Paul R. Masson & Jacob A. Frenkel & Morris Goldstein, 1991. "Characteristics of a Successful Exchange Rate System," IMF Occasional Papers 82, International Monetary Fund.
  7. Xavier Debrun, 2000. "Fiscal Rules in a Monetary Union: A Short-Run Analysis," Open Economies Review, Springer, vol. 11(4), pages 323-358, October. [Downloadable!] (restricted)
  8. Guillermo Calvo & Frederic S. Mishkin, 2003. "The Mirage of Exchange Rate Regimes for Emerging Market Countries," NBER Working Papers 9808, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. 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. [Downloadable!] (restricted)
  10. 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. [Downloadable!]
  11. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall. [Downloadable!]
  12. Ratna Sahay, 2005. "Stabilization, Debt, and Fiscal Policy in the Caribbean," IMF Working Papers 05/26, International Monetary Fund. [Downloadable!]
  13. Phebby Kufa & Saqib Rizavi & Anthony J. Pellechio, 2003. "Fiscal Sustainability and Policy Issues in the Eastern Caribbean Currency Union," IMF Working Papers 03/162, International Monetary Fund. [Downloadable!]
  14. Yan Sun, 2003. "Do Fixed Exchange Rates Induce More Fiscal Discipline?," IMF Working Papers 03/78, International Monetary Fund. [Downloadable!]
  15. Paolo Manasse & Axel Schimmelpfennig & Nouriel Roubini, 2003. "Predicting Sovereign Debt Crises," IMF Working Papers 03/221, International Monetary Fund. [Downloadable!]
  16. Helge Berger & George Kopits & István P. Székely, 2004. "Fiscal Indulgence in Central Europe: Loss of the External Anchor," IMF Working Papers 04/62, International Monetary Fund. [Downloadable!]
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  17. Carmen M. Reinhart, 2002. "Default, Currency Crises, and Sovereign Credit Ratings," World Bank Economic Review, Oxford University Press, vol. 16(2), pages 151-170, August.
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  18. Jürgen von Hagen & Ian Harden, 1996. "Budget Processes and Commitment to Fiscal Discipline," IMF Working Papers 96/78, International Monetary Fund.
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  19. Woo, Jaejoon, 2003. "Economic, political, and institutional determinants of public deficits," Journal of Public Economics, Elsevier, vol. 87(3-4), pages 387-426, March. [Downloadable!] (restricted)
  20. Giavazzi, Francesco & Pagano, Marco, 1988. "The advantage of tying one's hands : EMS discipline and Central Bank credibility," European Economic Review, Elsevier, vol. 32(5), pages 1055-1075, June. [Downloadable!] (restricted)
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  21. Beetsma, Roel M. W. J. & Bovenberg, A. Lans, 1999. "Does monetary unification lead to excessive debt accumulation?," Journal of Public Economics, Elsevier, vol. 74(3), pages 299-325, December. [Downloadable!] (restricted)
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  22. repec:rus:hseeco:123922 is not listed on IDEAS
Full references

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. 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. [Downloadable!]
  2. Stephanie Medina Cas & Rui Ota, 2008. "Big Government, High Debt, and Fiscal Adjustment in Small States," IMF Working Papers 08/39, International Monetary Fund. [Downloadable!]
  3. Shaun K. Roache, 2007. "Public Investment and Growth in the Eastern Caribbean," IMF Working Papers 07/124, International Monetary Fund. [Downloadable!]
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