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When Are Fixed Exchange Rates Really Fixed?

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  • Andres Velasco
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    Abstract

    This paper analyzes the sustainability of fixed exchange rates by extending the Barro-Gordon framework to a fully dynamic context in which the level of a state variable (in this case debt) determines the payoffs available to the government at each point in time. The model yields the following results. If debt is sufficiently low, there is an equilibrium in which the government does not devalue. For an intermediate range of debt levels, the government devalues in response to an attack but not otherwise, so that self-fulfilling attacks can occur. Finally, for yet another debt range there can also be sunspot equilibria in which an attack (and the corresponding devaluation) occurs with positive probability.

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    File URL: http://www.nber.org/papers/w5842.pdf
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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5842.

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    Date of creation: Nov 1996
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    Publication status: published as Journal of Development Economics, Vol. 54, no. 1 (October 1997): 5-25.
    Handle: RePEc:nbr:nberwo:5842

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    1. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 100(4), pages 1169-89, November.
    2. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-Fulfilling Debt Crises," Levine's Working Paper Archive 114, David K. Levine.
    3. Ozkan, F. Gulcin & Sutherland, Alan, 1998. "A currency crisis model with an optimising policymaker," Journal of International Economics, Elsevier, Elsevier, vol. 44(2), pages 339-364, April.
    4. V. V. Chari & Patrick J Kehoe, 1998. "Sustainable Plans," Levine's Working Paper Archive 600, David K. Levine.
    5. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
    6. 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.
    7. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, American Economic Association, vol. 76(1), pages 72-81, March.
    8. Klein, Michael W. & Marion, Nancy P., 1997. "Explaining the duration of exchange-rate pegs," Journal of Development Economics, Elsevier, Elsevier, vol. 54(2), pages 387-404, December.
    9. Ozkan, F Gulcin & Sutherland, Alan, 1995. "Policy Measures to Avoid a Currency Crisis," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 105(429), pages 510-19, March.
    10. Pierre-Richard Agenor & Jagdeep S. Bhandari & Robert P. Flood, 1991. "Speculative Attacks and Models of Balance-of-Payments Crises," NBER Working Papers 3919, National Bureau of Economic Research, Inc.
    11. Paul R. Masson & Allan Drazen, 1994. "Credibility of Policies Versus Credibility of Policymakers," IMF Working Papers 94/49, International Monetary Fund.
    12. Maurice Obstfeld., 1996. "Destabilizing Effects of Exchange-Rate Escape Clauses," Center for International and Development Economics Research (CIDER) Working Papers, University of California at Berkeley C96-075, University of California at Berkeley.
    13. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 15(4), pages 627-656, October.
    14. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
    15. Horn, Henrik & Persson, Torsten, 1988. "Exchange rate policy, wage formation and credibility," European Economic Review, Elsevier, Elsevier, vol. 32(8), pages 1621-1636, October.
    16. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(3), pages 473-91, June.
    17. Cukierman, Alex & Leiderman, Leonardo & Spiegel, Yossi, 1994. "Choosing the Width of Exchange Rate Bands - Credibility vs. Flexibility," CEPR Discussion Papers, C.E.P.R. Discussion Papers 907, C.E.P.R. Discussion Papers.
    18. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
    19. Bensaid, B.B. & Jeanne, O., 1995. "The Instability of Fixed Exchange Rate Systems when Raising the Nominal Interest Rate is Costly," Papers, Tilburg - Center for Economic Research 9536, Tilburg - Center for Economic Research.
    20. Pierre-Richard Agénor & Jagdeep S. Bhandari & Robert P. Flood, 1992. "Speculative Attacks and Models of Balance of Payments Crises," IMF Staff Papers, Palgrave Macmillan, vol. 39(2), pages 357-394, June.
    21. de Kock, Gabriel & Grilli, Vittorio, 1993. "Fiscal Policies and the Choice of Exchange Rate Regime," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 103(417), pages 347-58, March.
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    Cited by:
    1. Guillermo Javier Vúletin, 2002. "Regímenes Cambiarios y Performance Fiscal ¿Generan los Regímenes Fijos Mayor Disciplina que los Flexibles?," Department of Economics, Working Papers 042, Departamento de Economía, Facultad de Ciencias Económicas, Universidad Nacional de La Plata.
    2. Guillermo J. Vuletin, 2004. "Exchange Rate Regimes And Fiscal Performance. Do Fixed Exchange Rate Regimes Generate More Discipline Than Flexible Ones?," Econometric Society 2004 North American Winter Meetings, Econometric Society 474, Econometric Society.

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