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Fiscal Deficits, Exchange Rate Crises and Inflation

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  • Sweder van Wijnbergen

Abstract

The analysis focuses on the government budget constraint and the resolution of inconsistent implications of different policy instruments under that constraint. We show how, under floating exchange rates, external shocks or internal structural reforms may cause jumps in inflation and the exchange rate through their impact on the government budget. In order to achieve a sustainable reduction in inflation an exchange rate freeze or crawling peg is shown to require restrictions not only on domestic credit, but also on the rate of increase in interest-bearing public debt. We endogenize regime collapse by introducing rational speculation against the central bank, and show that if an exchange rate freeze collapses, post-collapse inflation will exceed the rate prevailing before the freeze started.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2130.

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Date of creation: Jan 1987
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Publication status: published as Review of Economic Studies, Vol. 58, no. 193 (1991): 81-92.
Handle: RePEc:nbr:nberwo:2130

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  1. Rudiger Dornbusch & Stanley Fischer, 1986. "Stopping hyperinflations past and present," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 122(1), pages 1-47, March.
  2. Jacob A. Frenkel & Assaf Razin, 1984. "Fiscal Policies, Debt, and International Economic Interdependence," NBER Working Papers 1266, National Bureau of Economic Research, Inc.
  3. 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.
  4. Buiter, Willem H, 1986. "Borrowing to Defend the Exchange Rate and the Timing and Magnitude of Speculative Attacks," CEPR Discussion Papers 95, C.E.P.R. Discussion Papers.
  5. Olivier J. Blanchard, 1984. "Debt, Deficits and Finite Horizons," NBER Working Papers 1389, National Bureau of Economic Research, Inc.
  6. Blanco, Herminio & Garber, Peter M, 1986. "Recurrent Devaluation and Speculative Attacks on the Mexican Peso," Journal of Political Economy, University of Chicago Press, vol. 94(1), pages 148-66, February.
  7. Flood, Robert P & Garber, Peter M, 1980. "An Economic Theory of Monetary Reform," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 24-58, February.
  8. Kharas, Homi, 1984. "The Long-Run Creditworthiness of Developing Countries: Theory and Practice," The Quarterly Journal of Economics, MIT Press, vol. 99(3), pages 415-39, August.
  9. Elhanan Helpman & Assaf Razin, 1985. "Exchange Rate Management: Intertemporal Tradoffs," NBER Working Papers 1590, National Bureau of Economic Research, Inc.
  10. Maurice Obstfeld, 1980. "Macroeconomic Policy, Exchange-Rate Dynamics, and Optimal Asset Accumulation," NBER Working Papers 0599, National Bureau of Economic Research, Inc.
  11. Stephen W. Salant & Dale W. Henderson, 1976. "Market anticipations, government policy, and the price of gold," International Finance Discussion Papers 81, Board of Governors of the Federal Reserve System (U.S.).
  12. Chamley, Christophe, 1985. "On a simple rule for the optimal inflation rate in second best taxation," Journal of Public Economics, Elsevier, vol. 26(1), pages 35-50, February.
  13. Drazen, Allan & Helpman, Elhanan, 1990. "Inflationary Consequences of Anticipated Macroeconomic Policies," Review of Economic Studies, Wiley Blackwell, vol. 57(1), pages 147-64, January.
  14. Liviatan, Nissan, 1984. "Tight money and inflation," Journal of Monetary Economics, Elsevier, vol. 13(1), pages 5-15, January.
  15. Salant, Stephen W & Henderson, Dale W, 1978. "Market Anticipations of Government Policies and the Price of Gold," Journal of Political Economy, University of Chicago Press, vol. 86(4), pages 627-48, August.
  16. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
  17. Buiter, Willem H, 1984. "Fiscal Policy in Open, Interdependent Economies," CEPR Discussion Papers 28, C.E.P.R. Discussion Papers.
  18. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  19. 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.
  20. Drazen, Allan, 1985. "Tight money and inflation: Further Results," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 113-120, January.
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