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Exchange Rate Crises and Fiscal Solvency

  • Betty Daniel

This paper combines insights from generation-one currency crisis models and the Fiscal Theory of the Price Level (FTPL) to create a new generation-one type model. Fiscal solvency is the fundamental generating crises, as in generation-one models. The initial fixed-exchange-rate policy entails risks, both to its sustainability and to the real value of government debt. The risks are due to stochastic surplus shocks and an upper bound on the present value of surpluses. Stochastic surplus shocks, changes in expectations of future fiscal commitments, and changes in the policy parameters can raise current desired debt or reduce expected future surpluses. Should the government's desired debt exceed the present-value of expected future surpluses, agents refuse to lend into this position of insolvency. The sudden stop of capital inflows creates a crisis. Equilibrium can be restored with some combination of policy switching and debt devaluation to restore fiscal solvency. The model can explain a wider variety of crises than generation one models, including those involving sovereign default. It is applied to explain crises in Argentina (2001), Mexico (1994-95), and Southeast Asia (1997), which did not fit the stylized facts of generation one models.

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File URL: http://www.albany.edu/economics/research/workingp/2008/xcrises12308.pdf
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Paper provided by University at Albany, SUNY, Department of Economics in its series Discussion Papers with number 08-09.

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Date of creation: 2008
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Handle: RePEc:nya:albaec:08-09
Contact details of provider: Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
Phone: (518) 442-4735
Fax: (518) 442-4736

Order Information: Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
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  1. Michael Woodford, 1995. "Price Level Determinacy Without Control of a Monetary Aggregate," NBER Working Papers 5204, National Bureau of Economic Research, Inc.
  2. Burnside, C. & Eichenbaum, M. & Rebelo, S., 1998. "Prospective Deficits and the Asian Currency Crisis," RCER Working Papers 458, University of Rochester - Center for Economic Research (RCER).
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  11. Cole, Harold L. & Kehoe, Timothy J., 1996. "A self-fulfilling model of Mexico's 1994-1995 debt crisis," Journal of International Economics, Elsevier, vol. 41(3-4), pages 309-330, November.
  12. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, vol. 4(3), pages 345-80.
  13. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, vol. 4(3), pages 381-99.
  14. Uribe, Martín, 2002. "A fiscal theory of sovereign risk," Working Paper Series 0187, European Central Bank.
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  17. Dupor, Bill, 2000. "Exchange rates and the fiscal theory of the price level," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 613-630, June.
  18. Betty Daniel, 2007. "The Fiscal Theory of the Price Level and Initial Government Debt," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(2), pages 193-206, April.
  19. Daniel, Betty C., 2001. "The fiscal theory of the price level in an open economy," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 293-308, October.
  20. 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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  24. Narayana Kocherlakota & Christopher Phelan, 1999. "Explaining the fiscal theory of the price level," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 14-23.
  25. Daniel, Betty C. & Shiamptanis, Christos, 2012. "Fiscal risk in a monetary union," European Economic Review, Elsevier, vol. 56(6), pages 1289-1309.
  26. Betty Daniel, 2000. "A Fiscal Theory of Currency Crises," Econometric Society World Congress 2000 Contributed Papers 0535, Econometric Society.
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