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Exchange Rates and Fiscal Adjustments: Evidence from the OECD and Implications for EMU

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Author Info
Lambertini, Luisa
Tavares, Jose

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Abstract

This paper characterizes monetary and exchange-rate policies during successful and unsuccessful fiscal adjustments by analyzing the OECD economies over the period 1970 to 1998. We find that successful adjustments are almost always preceded by large nominal and real exchange rate depreciations while unsuccessful adjustments are preceded by revaluations and followed by depreciations. The extreme adjustments of Ireland and Denmark in the 1990s fit this pattern of depreciation for success very closely. Early depreciation is a significant and quantitatively important predictor of the persistence of adjustment: each 1 percent of depreciation in the two years preceding a fiscal adjustment leads to approximately 2 percent increase in the probability of success. Since the size of the typical pre-adjustment depreciation is 5%, this is an important effect. When compared to an indicator of the composition of the fiscal adjustment, the reliance on spending cuts, the two variables have similar quantitative impacts on the likelihood of persistence. Our results are robust to alternative definitions of the depreciation period, the persistence of the adjustment, and whether we use effective, DM or US$ exchange rates. Monetary policy does not play a significant role in fiscal adjustments. Our results suggest that attaining persistent fiscal adjustment within EMU is likely to become a more costly endeavor than it was beforehand, as EMU members have adopted a single currency and therefore abandoned the use of exchange rate policies vis-`-vis each other.

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Paper provided by Universidade Nova de Lisboa, Faculdade de Economia in its series FEUNL Working Paper Series with number wp412.

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Length: 36 pages
Date of creation: 2002
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Handle: RePEc:unl:unlfep:wp412

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Lane, Philip R. & Perotti, Roberto, 1998. "The trade balance and fiscal policy in the OECD," European Economic Review, Elsevier, vol. 42(3-5), pages 887-895, May. [Downloadable!] (restricted)
  2. Feldstein, Martin, 1982. "Government deficits and aggregate demand," Journal of Monetary Economics, Elsevier, vol. 9(1), pages 1-20. [Downloadable!] (restricted)
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  3. Eichengreen, Barry, 1993. "European Monetary Unification," Journal of Economic Literature, American Economic Association, vol. 31(3), pages 1321-57, September. [Downloadable!] (restricted)
  4. Alberto Alesina & Roberto Perotti & José Tavares, 1998. "The Political Economy of Fiscal Adjustments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1998-1), pages 197-266. [Downloadable!]
  5. Francesco Giavazzi & Marco Pagano, 1990. "Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries," NBER Working Papers 3372, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. Barry Eichengreen & Charles Wyplosz, 1998. "The Stability Pact: more than a minor nuisance?," Economic Policy, CEPR, CES, MSH, vol. 13(26), pages 65-113, 04. [Downloadable!] (restricted)
  7. Maurice Obstfeld, 1999. "EMU: Ready, or Not?," NBER Working Papers 6682, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec.. [Downloadable!] (restricted)
  9. Giavazzi, Francesco & Jappelli, Tullio & Pagano, Marco, 2000. "Searching for non-linear effects of fiscal policy: Evidence from industrial and developing countries," European Economic Review, Elsevier, vol. 44(7), pages 1259-1289, June. [Downloadable!] (restricted)
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  10. Bertola, Giuseppe & Drazen, Allan, 1993. "Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity," American Economic Review, American Economic Association, vol. 83(1), pages 11-26, March. [Downloadable!] (restricted)
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  11. Francesco Giavazzi & Marco Pagano, 1996. "Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience," NBER Working Papers 5332, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Roberto Perotti, 1999. "Fiscal Policy In Good Times And Bad," The Quarterly Journal of Economics, MIT Press, vol. 114(4), pages 1399-1436, November. [Downloadable!] (restricted)
  13. Alesina, A. & Perotti, R., 1995. "Fiscal Expansions and Adjustments in OECD Countries," Discussion Papers 1995_25, Columbia University, Department of Economics.
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  1. Hjelm, Göran & Johansson, Martin W, 2002. "Structural Change in Fiscal Policy and The Permanence of Fiscal Contractions - The Case of Denmark and Ireland," Working Papers 2002:11, Lund University, Department of Economics. [Downloadable!]
  2. Naoko C. Kojo & Emanuele Baldacci & Arye L. Hillman, 2003. "Growth, Governance, and Fiscal Policy Transmission Channels in Low-Income Countries," IMF Working Papers 03/237, International Monetary Fund. [Downloadable!]
    Other versions:
  3. Emanuele Baldacci & Benedict J. Clements & Sanjeev Gupta & Erwin Tiongson, 2003. "What Sustains Fiscal Consolidations in Emerging Market Countries?," IMF Working Papers 03/224, International Monetary Fund. [Downloadable!]
  4. Sanjeev Gupta & Emanuele Baldacci & Benedict Clements & Erwin R. Tiongson, 2005. "What sustains fiscal consolidations in emerging market countries?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 10(4), pages 307-321. [Downloadable!]
  5. Paulo Roberto Arvate & Marcos Felipe Mendes Lopes, 2007. "Institutional Changes, Incentive Schemes And The Decision To Undertake Fiscal Adjustments," Anais do XXXV Encontro Nacional de Economia [Proceedings of the 35th Brazilian Economics Meeting] 010, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics]. [Downloadable!]
  6. Carlos Mulas-Granados & Emanuele Baldacci & Benedict J. Clements & Sanjeev Gupta, 2004. "Front-Loaded or Back-Loaded Fiscal Adjustments: What Works in Emerging Market Economies?," IMF Working Papers 04/157, International Monetary Fund. [Downloadable!]
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