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Fiscal Prerequisites for a Viable Managed Exchange Rate Regime: A Non-technical Eclectic Introduction

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  • Willem H. Buiter

Abstract

The paper first reviews the budget identities of the fiscal and monetary authorities and the solvency constraint or present value budget-constraint of the consolidated public sector, for closed and open economies. It then discusses the new conventional wisdom concerning the fiscal roots of inflation and the budgetary prerequisites for generating and stopping hyperinflation. The popular rational expectations "Unpleasant Monetarist Arithmetic" model of Sargent and Wallace has ambiguous inflation implications from an increase in the fundamental deficit and is incapable of generating hyperinflation. The only runaway, explosive or unstable behavior it can exhibit is "hyperdeflation"! In the open economy, the need to maintain a managed exchange rate regime does not impose any constraint on the growth rate of domestic credit, arising through the government's need to remain solvent. Obstfeld's proposition to the contrary is due to the omission of government bonds and borrowing. There is not yet any "deep structural" theory justifying the (exogenous) lower bounds on the stock of foreign exchange reserves characteristic of the collapsing exchange rate literature. Absent such a theory of "international liquidity," one cannot model satisfactorily a foreign exchange crisis that is not at the same time a government solvency crisis. Given such a lower bound, the existence or absence of a pecuniary opportunity cost to holding reserves is shown to condition the fiscal and financial actions consistent with prolonged survival of the managed exchange rate regime.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2041.

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Date of creation: May 1987
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Handle: RePEc:nbr:nberwo:2041

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  1. Buiter, Willem H., 1987. "Borrowing to defend the exchange rate and the timing and magnitude of speculative attacks," Journal of International Economics, Elsevier, vol. 23(3-4), pages 221-239, November.
  2. Connolly, Michael B & Taylor, Dean, 1984. "The Exact Timing of the Collapse of an Exchange Rate Regime and Its Impact on the Relative Price of Traded Goods," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(2), pages 194-207, May.
  3. Maurice Obstfeld, 1984. "Balance-of-Payments Crises and Devaluation," NBER Working Papers 1103, National Bureau of Economic Research, Inc.
  4. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  5. Elhanan Helpman & Assaf Razin, 1987. "Exchange Rate Management: Intertemporal Tradoffs," NBER Working Papers 1590, National Bureau of Economic Research, Inc.
  6. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  7. 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.
  8. Willem H. Buiter, 1982. "Comment on T. J. Sargent and N. Wallace: "Some Unpleasant Monetarist Arithmetic"," NBER Working Papers 0867, National Bureau of Economic Research, Inc.
  9. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
  10. Bennett T. McCallum, 1984. "Are Bond-Financed Deficits Inflationary? A Ricardian Analysis," NBER Working Papers 0905, National Bureau of Economic Research, Inc.
  11. James Tobin & Willem H. Buiter, 1974. "Long Run Effects of Fiscal and Monetary Policy on Aggregate Demand," Cowles Foundation Discussion Papers 384, Cowles Foundation for Research in Economics, Yale University.
  12. Blinder, Alan S. & Solow, Robert M., 1973. "Does fiscal policy matter?," Journal of Public Economics, Elsevier, vol. 2(4), pages 319-337.
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