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Fiscal Devaluations

  • Emmanuel Farhi
  • Gita Gopinath
  • Oleg Itskhoki

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 dynamic New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions- producer or local currency pricing, along with nominal wage stickiness; under arbitrary degrees of asset market completeness and for general stochastic sequences of 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 are revenue neutral. 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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17662.

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Date of creation: Dec 2011
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Publication status: published as “Fiscal Devaluations” (with Gita Gopinath and Oleg Itskhoki) Review of Economic Studies, forthcoming.
Handle: RePEc:nbr:nberwo:17662
Note: EFG IFM ITI ME
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