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Exchange Rates and Fiscal Adjustments: Evidence from the OECD and Implications for EMU

  • Lambertini, Luisa
  • Tavares, Jose

This paper characterizes monetary and exchange-rate policies during successful and unsuccessful fiscal adjustments by analyzing the OECD economies over the period 1970 to 1998. We find that successful adjustments are almost always preceded by large nominal and real exchange rate depreciations while unsuccessful adjustments are preceded by revaluations and followed by depreciations. The extreme adjustments of Ireland and Denmark in the 1990s fit this pattern of depreciation for success very closely. Early depreciation is a significant and quantitatively important predictor of the persistence of adjustment: each 1 percent of depreciation in the two years preceding a fiscal adjustment leads to approximately 2 percent increase in the probability of success. Since the size of the typical pre-adjustment depreciation is 5%, this is an important effect. When compared to an indicator of the composition of the fiscal adjustment, the reliance on spending cuts, the two variables have similar quantitative impacts on the likelihood of persistence. Our results are robust to alternative definitions of the depreciation period, the persistence of the adjustment, and whether we use effective, DM or US$ exchange rates. Monetary policy does not play a significant role in fiscal adjustments. Our results suggest that attaining persistent fiscal adjustment within EMU is likely to become a more costly endeavor than it was beforehand, as EMU members have adopted a single currency and therefore abandoned the use of exchange rate policies vis-`-vis each other.

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Paper provided by Universidade Nova de Lisboa, Faculdade de Economia in its series FEUNL Working Paper Series with number wp412.

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Length: 36 pages
Date of creation: 2002
Date of revision:
Handle: RePEc:unl:unlfep:wp412
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  1. Lane, Philip R. & Perotti, Roberto, 1998. "The trade balance and fiscal policy in the OECD," European Economic Review, Elsevier, vol. 42(3-5), pages 887-895, May.
  2. Eichengreen, Barry, 1993. "European Monetary Unification," Journal of Economic Literature, American Economic Association, vol. 31(3), pages 1321-57, September.
  3. Obstfeld, M., 1998. "EMU: Ready or Not?," Princeton Essays in International Economics 209, International Economics Section, Departement of Economics Princeton University,.
  4. Feldstein, Martin, 1982. "Government deficits and aggregate demand," Journal of Monetary Economics, Elsevier, vol. 9(1), pages 1-20.
  5. Francesco Giavazzi & Marco Pagano, 1990. "Can Severe Fiscal Contractions Be Expansionary? Tales of two Small Euopean Countries," Working Papers 89, Dipartimento Scienze Economiche, Universita' di Bologna.
  6. Bertola, Giuseppe & Drazen, Allan, 1991. "Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity," CEPR Discussion Papers 599, C.E.P.R. Discussion Papers.
  7. Roberto Perotti, 1999. "Fiscal Policy In Good Times And Bad," The Quarterly Journal of Economics, MIT Press, vol. 114(4), pages 1399-1436, November.
  8. Barro, Robert J., 1974. "Are Government Bonds Net Wealth?," Scholarly Articles 3451399, Harvard University Department of Economics.
  9. Alesina, Alberto Francesco & Perotti, Roberto & Tavares, Jose, 1998. "The Political Economy of Fiscal Adjustments," Scholarly Articles 12553724, Harvard University Department of Economics.
  10. Alberto Alesina & Roberto Perotti, 1997. "Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects," IMF Staff Papers, Palgrave Macmillan, vol. 44(2), pages 210-248, June.
  11. Francesco Giavazzi & Tullio Jappelli & Marco Pagano, 2000. "Searching for Non-Linear Effects of Fiscal Policy: Evidence from Industrial and Developing Countries," NBER Working Papers 7460, National Bureau of Economic Research, Inc.
  12. Barry Eichengreen & Charles Wyplosz, 1998. "The Stability Pact: more than a minor nuisance?," Economic Policy, CEPR;CES;MSH, vol. 13(26), pages 65-113, 04.
  13. Francesco Giavazzi & Marco Pagano, 1995. "Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience," NBER Working Papers 5332, National Bureau of Economic Research, Inc.
  14. Schuknecht, Ludger, 1998. "Fiscal policy cycles and the exchange regime in developing countries," WTO Staff Working Papers ERAD-97-04, World Trade Organization (WTO), Economic Research and Statistics Division.
  15. Alberto Alesina & Roberto Perotti & José Tavares, 1998. "The Political Economy of Fiscal Adjustments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1), pages 197-266.
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