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Foreign Debt and Fear of Floating: A Theoretical Exploration

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  • Michael Bleaney
  • F. Gulcin Ozkan

Abstract

This paper explores the relationship between the denomination of public debt and the choice of exchange rate regime. Unlike indexed domestic debt, foreign debt is subject to valuation effects from real exchange rate shocks. In a standard set-up, where a peg functions only as a nominal anchor, more foreign debt makes pegging less attractive, because it increases the value of a flexible exchange rate as a shock absorber. This result can be reversed if we incorporate the stylized fact that pegs have lower real exchange rate volatility, and if external shocks are sufficiently large relative to domestic shocks.

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Paper provided by University of Nottingham, School of Economics in its series Discussion Papers with number 08/03.

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Handle: RePEc:not:notecp:08/03

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Keywords: inflation; output; public debt and exchange rate regimes;

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  1. Michael Bleaney & Manuela Francisco, 2008. "Balance sheet effects and the choice of exchange rate regime in developing countries," The Journal of International Trade & Economic Development, Taylor & Francis Journals, vol. 17(2), pages 297-310.
  2. Flood, Robert P & Rose, Andrew K, 1993. "Fixing Exchange Rates: A Virtual Quest for Fundamentals," CEPR Discussion Papers 838, C.E.P.R. Discussion Papers.
  3. Falcetti, Elisabetta & Missale, Alessandro, 2002. "Public debt indexation and denomination with an independent central bank," European Economic Review, Elsevier, vol. 46(10), pages 1825-1850, December.
  4. Ricardo Hausmann & Ugo Panizza & Ernesto H. Stein, 2000. "Why Do Countries Float the Way They Float?," Research Department Publications 4205, Inter-American Development Bank, Research Department.
  5. Beetsma, Roel M. W. J. & Bovenberg, A. Lans, 1997. "Central bank independence and public debt policy," Journal of Economic Dynamics and Control, Elsevier, vol. 21(4-5), pages 873-894, May.
  6. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
  7. Marianne Baxter & Alan C. Stockman, 1990. "Business Cycles and the Exchange Rate System: Some International Evidence," NBER Working Papers 2689, National Bureau of Economic Research, Inc.
  8. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412 National Bureau of Economic Research, Inc.
  9. Jeffrey A. Frankel, 2005. "Contractionary Currency Crashes in Developing Countries," NBER Working Papers 11508, National Bureau of Economic Research, Inc.
  10. Hasan, Shahriar & Wallace, Myles, 1996. "Real exchange rate volatility and exchange rate regimes: Evidence from long-term data," Economics Letters, Elsevier, vol. 52(1), pages 67-73, July.
  11. Reinhart, Carmen & Rogoff, Kenneth, 2004. "The modern history of exchange rate arrangements: A reinterpretation," MPRA Paper 14070, University Library of Munich, Germany.
  12. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
  13. Cook, David, 2004. "Monetary policy in emerging markets: Can liability dollarization explain contractionary devaluations?," Journal of Monetary Economics, Elsevier, vol. 51(6), pages 1155-1181, September.
  14. Ozkan, F Gulcin, 2000. " Who Wants an Independent Central Bank? Monetary Policy-Making and Politics," Scandinavian Journal of Economics, Wiley Blackwell, vol. 102(4), pages 621-43, December.
  15. Luis Felipe Cespedes & Roberto Chang & Andres Velasco, 2000. "Balance Sheets and Exchange Rate Policy," NBER Working Papers 7840, National Bureau of Economic Research, Inc.
  16. 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.
  17. Honig, Adam, 2005. "Fear of floating and domestic liability dollarization," Emerging Markets Review, Elsevier, vol. 6(3), pages 289-307, September.
  18. Helge Berger & Henrik Jensen & Guttorm Schjelderup, 2001. "To Peg or Not To Peg? A Simple Model of Exchange Rate Regime Choice In Small Economies," CESifo Working Paper Series 468, CESifo Group Munich.
  19. Gupta, Poonam & Mishra, Deepak & Sahay, Ratna, 2007. "Behavior of output during currency crises," Journal of International Economics, Elsevier, vol. 72(2), pages 428-450, July.
  20. Baxter, Marianne & Stockman, Alan C., 1989. "Business cycles and the exchange-rate regime : Some international evidence," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 377-400, May.
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