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The structure of public debt and the choice of exchange rate regime

  • Michael Bleaney
  • F. Gulcin Ozkan

This paper explores the relationship between the denomination of public debt and the choice of exchange rate regime. Three types of debt (nominal, indexed, and foreign) and two regimes (fixed and flexible) are considered. Indexed debt is insulated against unexpected inflation. The real (domestic-currency) value of foreign debt is subject to valuation effects from real exchange rate shocks. The `fear-of-floating' result, that foreign debt makes pegging more attractive, is shown to hold unambiguously only if the peg is fully credible. If the peg lacks credibility, a critical factor is the perceived likelihood of using the `escape clause' of a switch to a float, which raises the costs of pegging. Foreign debt increases the temptation to resort to the escape clause, so when a peg is not fully credible (as is almost always the case in reality), pegging tends to be less attractive than floating in the presence of foreign debt.

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Article provided by Canadian Economics Association in its journal Canadian Journal of Economics.

Volume (Year): 44 (2011)
Issue (Month): 1 (February)
Pages: 325-339

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Handle: RePEc:cje:issued:v:44:y:2011:i:1:p:325-339
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  1. Maurice Obstfeld., 1996. "Destabilizing Effects of Exchange-Rate Escape Clauses," Center for International and Development Economics Research (CIDER) Working Papers C96-075, University of California at Berkeley.
  2. Maurice Obstfeld & Kenneth Rogoff, 1995. "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 73-96, Fall.
  3. Jeffrey A. Frankel & Andrew K. Rose, 1996. "Currency crashes in emerging markets: an empirical treatment," International Finance Discussion Papers 534, Board of Governors of the Federal Reserve System (U.S.).
  4. Berger, Helge & Jensen, Henrik & Schjelderup, Guttorm, 2001. "To peg or not to peg?: A simple model of exchange rate regime choice in small economies," Economics Letters, Elsevier, vol. 73(2), pages 161-167, November.
  5. Reinhart, Carmen & Kaminsky, Graciela & Lizondo, Saul, 1998. "Leading Indicators of Currency Crises," MPRA Paper 6981, University Library of Munich, Germany.
  6. Carmen M. Reinhart & Kenneth S. Rogoff, 2002. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Papers 8963, National Bureau of Economic Research, Inc.
  7. Andrew K. Rose, 2006. "A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed," NBER Working Papers 12711, National Bureau of Economic Research, Inc.
  8. Jeffrey A. Frankel, 2005. "Contractionary Currency Crashes in Developing Countries," NBER Working Papers 11508, National Bureau of Economic Research, Inc.
  9. 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.
  10. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  11. 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.
  12. 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.
  13. Chang, Roberto & Velasco, Andres, 2006. "Currency mismatches and monetary policy: A tale of two equilibria," Journal of International Economics, Elsevier, vol. 69(1), pages 150-175, June.
  14. Honig, Adam, 2005. "Fear of floating and domestic liability dollarization," Emerging Markets Review, Elsevier, vol. 6(3), pages 289-307, September.
  15. 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.
  16. 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.
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