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Fiscal Devaluations

  • Farhi, Emmanuel
  • Gopinath, Gita
  • Itskhoki, Oleg

We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a standard New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions -- producer or local currency pricing, along with nominal wage stickiness; under alternative asset market structures, and for anticipated and unanticipated devaluations. There are two types of fiscal policies equivalent to an exchange rate devaluation -- one, a uniform increase in import tariff and export subsidy, and two, a value-added tax increase and a uniform payroll tax reduction. When the devaluations are anticipated, these policies need to be supplemented with a consumption tax reduction and an income tax increase. These policies have zero impact on fiscal revenues. In certain cases equivalence requires, in addition, a partial default on foreign bond holders. We discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8721.

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Date of creation: Dec 2011
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Handle: RePEc:cpr:ceprdp:8721
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