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

  • Buiter, Willem H.

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 129.

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Date of creation: Oct 1986
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Handle: RePEc:cpr:ceprdp:129
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  1. Blinder, Alan S. & Solow, Robert M., 1973. "Does fiscal policy matter?," Journal of Public Economics, Elsevier, vol. 2(4), pages 319-337.
  2. Obstfeld, Maurice, 1984. "Balance-of-Payments Crises and Devaluation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(2), pages 208-17, May.
  3. Buiter, Willem H., 1986. "Borrowing to Defend the Exchange Rate and the Timing and Magnitude of Speculative Attacks," CEPR Discussion Papers 95, C.E.P.R. Discussion Papers.
  4. James Tobin & Willem H. Buiter, 1974. "Long Run Effects of Fiscal and Monetary Policy on Aggregate Demand," Cowles Foundation Discussion Papers 384, Cowles Foundation for Research in Economics, Yale University.
  5. Bennett T. McCallum, 1982. "Are Bond-Financed Deficits Inflationary? A Ricardian Analysis," NBER Working Papers 0905, National Bureau of Economic Research, Inc.
  6. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  7. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  8. Connolly, Michael B & Taylor, Dean, 1984. "The Exact Timing of the Collapse of an Exchange Rate Regime and Its Impact on the Relative Price of Traded Goods," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(2), pages 194-207, May.
  9. Helpman, Elhanan & Razin, Assaf, 1987. "Exchange Rate Management: Intertemporal Tradeoffs," American Economic Review, American Economic Association, vol. 77(1), pages 107-23, March.
  10. Willem H. Buiter, 1982. "Comment on T. J. Sargent and N. Wallace: "Some Unpleasant Monetarist Arithmetic"," NBER Working Papers 0867, National Bureau of Economic Research, Inc.
  11. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
  12. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
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