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Exchange Rate Policy and Debt Crises in Emerging Economies

  • Peter Montiel
  • Samir Jahjah

We explore a model intended to capture the interaction between exchange rate policy, fiscal policy, and outright default on foreign-currency denominated debt. We examine how the exchange rate affects the supply of short-term debt facing the government. We show that under a credible hard peg (currency board), default is a more likely outcome, even without an exceptionally large short-term debt, precisely because a devaluation is not an option. In a more conventional fixed peg, it can be optimal for the government to choose a level of the exchange rate that would be likely to result in partial or complete debt default. Depending on the exchange rate regime, multiple equilibria exist, in one of which the interest rate is high, the exchange rate is overvalued, output is low, and default is high. Under a hard peg, there is a unique equilibrium.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 03/60.

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Length: 22
Date of creation: 01 Mar 2003
Date of revision:
Handle: RePEc:imf:imfwpa:03/60
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  1. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  2. James Conklin, 1998. "The Theory of Sovereign Debt and Spain under Philip II," Journal of Political Economy, University of Chicago Press, vol. 106(3), pages 483-513, June.
  3. Reinhart, Carmen & Calvo, Guillermo, 2001. "Fixing for your life," MPRA Paper 13873, University Library of Munich, Germany.
  4. Douglas W. Diamond & Raghuram G. Rajan, . "Banks, Short Term Debt and Financial Crises: Theory, Policy Implications and Applications."," CRSP working papers 518, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  5. Bulow, Jeremy & Rogoff, Kenneth S., 1989. "A Constant Recontracting Model of Sovereign Debt," Scholarly Articles 12491028, Harvard University Department of Economics.
  6. Giavazzi, Francesco & Pagano, Marco, 1988. "The advantage of tying one's hands : EMS discipline and Central Bank credibility," European Economic Review, Elsevier, vol. 32(5), pages 1055-1075, June.
  7. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  8. Barry Eichengreen., 1990. "Historical Research on International Lending and Debt," Economics Working Papers 90-153, University of California at Berkeley.
  9. Carmen M. Reinhart, 2002. "Default, Currency Crises and Sovereign Credit Ratings," NBER Working Papers 8738, National Bureau of Economic Research, Inc.
  10. Christopher A. Sims, 2001. "Fiscal consequences for Mexico of adopting the dollar," Proceedings, Federal Reserve Bank of Cleveland, pages 597-625.
  11. Harold L. Cole & Patrick J. Kehoe, 1996. "Reputation spillover across relationships: reviving reputation models of debt," Staff Report 209, Federal Reserve Bank of Minneapolis.
  12. Wiesner, Eduardo, 1985. "Latin American Debt: Lessons and Pending Issues," American Economic Review, American Economic Association, vol. 75(2), pages 191-95, May.
  13. Catherine A. Pattillo & Andrew Berg & Gian-Maria Milesi-Ferretti & Eduardo Borensztein, 2000. "Anticipating Balance of Payments Crises; The Role of Early Warning Systems," IMF Occasional Papers 186, International Monetary Fund.
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