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Fiscal Discipline and Exchange Rate Regimes; Evidence From the Caribbean

Listed author(s):
  • Rupa Duttagupta
  • Guillermo Tolosa
Registered author(s):

    This paper assesses the nature of fiscal discipline under alternative exchange rate regimes. First, it shows in a simple theoretical framework that fiscal agencies under a currency union with a fixed exchange rate can have the largest incentive to overspend or "free-ride" (compared to those under other exchange rate regimes) owing to their ability to spread the costs of overspending in terms of the inflation tax across both time-given the fixed exchange rate-and space-given the currency union. In contrast, such free-riding behavior does not arise under flexible regimes owing to the immediate inflationary impact of spending. Next, empirically, it shows that fiscal stances in countries with fixed pegs and currency unions regime demonstrate greater free-riding behavior than countries with more flexible regimes in 15 Caribbean countries during 1983-2004.

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    File URL: http://www.imf.org/external/pubs/cat/longres.aspx?sk=19138
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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/119.

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    Length: 37
    Date of creation: 01 May 2006
    Handle: RePEc:imf:imfwpa:06/119
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    1. Alesina, Alberto & Hausmann, Ricardo & Hommes, Rudolf & Stein, Ernesto H., 1996. "Budget institutions and fiscal performance in Latin America," Sede de la CEPAL en Santiago (Estudios e Investigaciones) 34295, Naciones Unidas Comisión Económica para América Latina y el Caribe (CEPAL).
    2. Anthony J. Pellechio & Saqib Rizavi & Phebby Kufa, 2003. "Fiscal Sustainability and Policy Issues in the Eastern Caribbean Currency Union," IMF Working Papers 03/162, International Monetary Fund.
    3. Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
    4. Chari, V.V. & Kehoe, Patrick J., 2007. "On the need for fiscal constraints in a monetary union," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2399-2408, November.
    5. Beetsma, Roel & Bovenberg, A Lans, 1995. "Does Monetary Unification Lead to Excessive Debt Accumulation?," CEPR Discussion Papers 1299, C.E.P.R. Discussion Papers.
    6. Francesco Giavazzi & Marco Pagano, 1991. "The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 303-330 National Bureau of Economic Research, Inc.
    7. Axel Schimmelpfennig & Nouriel Roubini & Paolo Manasse, 2003. "Predicting Sovereign Debt Crises," IMF Working Papers 03/221, International Monetary Fund.
    8. repec:rus:hseeco:123922 is not listed on IDEAS
    9. George Kopits & Helge Berger & Istvan P Szekely, 2004. "Fiscal Indulgence in Central Europe; Loss of the External Anchor," IMF Working Papers 04/62, International Monetary Fund.
    10. Aaron Tornell & Andres Velasco, 1995. "Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?," NBER Working Papers 5108, National Bureau of Economic Research, Inc.
    11. Carmen M. Reinhart, 2002. "Default, Currency Crises and Sovereign Credit Ratings," NBER Working Papers 8738, National Bureau of Economic Research, Inc.
    12. Enrique Alberola & Luis Molina, 2003. "What Does Really Discipline Fiscal Policy in Emerging Markets?: the Role and Dynamics of Exchange Rate Regimes," Money Affairs, Centro de Estudios Monetarios Latinoamericanos, vol. 0(2), pages 165-192, July-Dece.
    13. Tobias N. Rasmussen, 2004. "Macroeconomic Implications of Natural Disasters in the Caribbean," IMF Working Papers 04/224, International Monetary Fund.
    14. Guillermo A. Calvo & Frederic S. Mishkin, 2003. "The Mirage of Exchange Rate Regimes for Emerging Market Countries," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 99-118, Fall.
    15. Shang-Jin Wei & Irina Tytell, 2004. "Does Financial Globalization Induce Better Macroeconomic Policies?," IMF Working Papers 04/84, International Monetary Fund.
    16. International Monetary Fund, 1996. "Budget Processes and Commitment to Fiscal Discipline," IMF Working Papers 96/78, International Monetary Fund.
    17. Paul R Masson & Morris Goldstein & Jacob A. Frenkel, 1991. "Characteristics of a Successful Exchange Rate System," IMF Occasional Papers 82, International Monetary Fund.
    18. Yan Sun, 2003. "Do Fixed Exchange Rates Induce More Fiscal Discipline?," IMF Working Papers 03/78, International Monetary Fund.
    19. Fatás, Antonio & Rose, Andrew K, 2001. "Do Monetary Handcuffs Restrain Leviathan? Fiscal Policy in Extreme Exchange Rate Regimes," CEPR Discussion Papers 2692, C.E.P.R. Discussion Papers.
    20. Graciela L. Kaminsky & Carmen M. Reinhart & Carlos A. Vegh, 2004. "When it Rains, it Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Working Papers 10780, National Bureau of Economic Research, Inc.
    21. Xavier Debrun, 2000. "Fiscal Rules in a Monetary Union: A Short-Run Analysis," Open Economies Review, Springer, vol. 11(4), pages 323-358, October.
    22. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages -.
    23. Woo, Jaejoon, 2003. "Economic, political, and institutional determinants of public deficits," Journal of Public Economics, Elsevier, vol. 87(3-4), pages 387-426, March.
    24. Taimur Baig & Abdul d Abiad, 2005. "Underlying Factors Driving Fiscal Effort in Emerging Market Economies," IMF Working Papers 05/106, International Monetary Fund.
    25. Ratna Sahay, 2005. "Stabilization, Debt, and Fiscal Policy in the Caribbean," IMF Working Papers 05/26, International Monetary Fund.
    26. Bergin, Paul R., 2000. "Fiscal solvency and price level determination in a monetary union," Journal of Monetary Economics, Elsevier, vol. 45(1), pages 37-53, February.
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