Fiscal Prerequisites for a Viable Managed Exchange Rate Regime: A Non-Technical Eclectic Introduction

The paper first reviews the budget identities of the fiscal and monetary authorities and the solvency constraint or present value budget constraint of the consolidated public sector, for both closed and open economies. It then discusses the new conventional wisdom concerning the fiscal roots of inflation and the budgetary prerequisites for generating and stopping hyperinflation. The popular rational expectations model of "Unpleasant Monetarist Arithmetic" of Sargent and Wallace yields ambiguous predictions concerning the response of inflation to an increase in the fundamental deficit. In addition the model is incapable of generating hyperinflation: the only runaway, explosive or unstable behaviour the model can exhibit is "hyperdeflation"] In the open economy, the need to maintain a managed exchange rate regime and the government's need to remain solvent do not impose any constraint on the growth rate of domestic credit. Obstfeld's proposition to the contrary is due to the omission of government bonds and borrowing in his analysis. There is not yet any "deep structural" theory justifying the (exogenous) lower bounds on the stock of foreign exchange reserves which are a characteristic assumption of the literature on collapsing exchange rate regimes. In the absence of such a theory of "international liquidity", one cannot construct a satisfactory model of a foreign exchange crisis that is not at the same time a government solvency crisis. If it is assumed that such lower bounds do exist, the existence of a pecuniary opportunity cost to holding reserves influences whether particular fiscal and financial policy choices are consistent with the prolonged survival of a managed exchange rate regime.