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Exchange Rate Crises and Fiscal Solvency

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  • Betty Daniel

Abstract

This paper combines insights from generation-one currency crisis models and the Fiscal Theory of the Price Level (FTPL) to create a new generation-one type model. Fiscal solvency is the fundamental generating crises, as in generation-one models. The initial fixed-exchange-rate policy entails risks, both to its sustainability and to the real value of government debt. The risks are due to stochastic surplus shocks and an upper bound on the present value of surpluses. Stochastic surplus shocks, changes in expectations of future fiscal commitments, and changes in the policy parameters can raise current desired debt or reduce expected future surpluses. Should the government's desired debt exceed the present-value of expected future surpluses, agents refuse to lend into this position of insolvency. The sudden stop of capital inflows creates a crisis. Equilibrium can be restored with some combination of policy switching and debt devaluation to restore fiscal solvency. The model can explain a wider variety of crises than generation one models, including those involving sovereign default. It is applied to explain crises in Argentina (2001), Mexico (1994-95), and Southeast Asia (1997), which did not fit the stylized facts of generation one models.

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Bibliographic Info

Paper provided by University at Albany, SUNY, Department of Economics in its series Discussion Papers with number 08-09.

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Date of creation: 2008
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Handle: RePEc:nya:albaec:08-09

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Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
Phone: (518) 442-4735
Fax: (518) 442-4736

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Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
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  1. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1998. "Prospective deficits and the Asian currency crisis," Working Paper Series, Federal Reserve Bank of Chicago WP-98-5, Federal Reserve Bank of Chicago.
  2. Betty Daniel, 2000. "A Fiscal Theory of Currency Crises," Econometric Society World Congress 2000 Contributed Papers 0535, Econometric Society.
  3. Troy Davig & Eric M. Leeper & Hess Chung, 2004. "Monetary and Fiscal Policy Switching," NBER Working Papers 10362, National Bureau of Economic Research, Inc.
  4. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, Springer, vol. 4(3), pages 345-80.
  5. Narayana Kocherlakota & Christopher Phelan, 1999. "Explaining the fiscal theory of the price level," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Fall, pages 14-23.
  6. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, Springer, vol. 4(3), pages 381-99.
  7. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 87(5), pages 940-71, October.
  8. Troy Davig & Eric M. Leeper, 2007. "Fluctuating Macro Policies and the Fiscal Theory," NBER Chapters, in: NBER Macroeconomics Annual 2006, Volume 21, pages 247-316 National Bureau of Economic Research, Inc.
  9. Betty Daniel & Christos Shiamptanis, 2008. "Fiscal Risk in a Monetary Union," Discussion Papers, University at Albany, SUNY, Department of Economics 08-12, University at Albany, SUNY, Department of Economics.
  10. Dupor, Bill, 2000. "Exchange rates and the fiscal theory of the price level," Journal of Monetary Economics, Elsevier, Elsevier, vol. 45(3), pages 613-630, June.
  11. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 33(3), pages 669-728, August.
  12. Cole, Harold L. & Kehoe, Timothy J., 1996. "A self-fulfilling model of Mexico's 1994-1995 debt crisis," Journal of International Economics, Elsevier, Elsevier, vol. 41(3-4), pages 309-330, November.
  13. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, pages 519-546.
  14. John H. Cochrane, 1998. "A Frictionless View of U.S. Inflation," NBER Working Papers 6646, National Bureau of Economic Research, Inc.
  15. Michael Woodford, 1995. "Price Level Determinacy Without Control of a Monetary Aggregate," NBER Working Papers 5204, National Bureau of Economic Research, Inc.
  16. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 27(1), pages 129-147, February.
  17. Lawrence J. Christiano & Terry J. Fitzgerald, 2000. "Understanding the Fiscal Theory of the Price Level," NBER Working Papers 7668, National Bureau of Economic Research, Inc.
  18. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, Elsevier, vol. 17(1-2), pages 1-13, August.
  19. Cochrane, John H., 2005. "Money as stock," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(3), pages 501-528, April.
  20. Guillermo A. Calvo & Enrique G. Mendoza, 1996. "Mexico's balance-of-payments crisis: a chronicle of death foretold," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 545, Board of Governors of the Federal Reserve System (U.S.).
  21. Uribe, Martín, 2002. "A fiscal theory of sovereign risk," Working Paper Series, European Central Bank 0187, European Central Bank.
  22. Michael Kumhof, 2004. "Fiscal Crisis Resolution: Taxation Versus Inflation," 2004 Meeting Papers, Society for Economic Dynamics 874, Society for Economic Dynamics.
  23. Daniel, Betty C., 2001. "The fiscal theory of the price level in an open economy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 48(2), pages 293-308, October.
  24. Betty Daniel, 2007. "The Fiscal Theory of the Price Level and Initial Government Debt," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(2), pages 193-206, April.
  25. Bernheim, B Douglas, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 23(3), pages 540-42, August.
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Citations

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Cited by:
  1. Betty C. Daniel & Christos Shiamptanis, 2010. "Sovereign Default Risk in a Monetary Union," Working Papers, Central Bank of Cyprus 2010-3, Central Bank of Cyprus.
  2. Betty Daniel & Christos Shiamptanis, 2012. "Pushing the Limit? Fiscal Policy in the European Monetary Union," Working Papers, Ryerson University, Department of Economics 033, Ryerson University, Department of Economics.
  3. Betty C. Daniel & Christos Shiamptanis, 2009. "Fiscal Policy in the European Monetary Union," Working Papers, Central Bank of Cyprus 2009-1, Central Bank of Cyprus.
  4. Betty Daniel & Christos Shiamptanis, 2008. "Fiscal Risk in a Monetary Union," Discussion Papers, University at Albany, SUNY, Department of Economics 08-12, University at Albany, SUNY, Department of Economics.
  5. Sottile, Pedro, 2013. "On the political determinants of sovereign risk: Evidence from a Markov-switching vector autoregressive model for Argentina," Emerging Markets Review, Elsevier, Elsevier, vol. 15(C), pages 160-185.

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