Do Fixed Exchange Rates Induce More Fiscal Discipline?
April 1, 2003
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Summary
Conventional wisdom has held that a fixed exchange rate regime induces more fiscal discipline, but Tornell and Velasco (1995, 1998) argue the opposite. Using a dynamic model with fragmented fiscal policymaking, this paper evaluates the two arguments in a single framework and shows that (1) future punishment against fiscal laxity exists under both fixed and flexible regimes; (2) fiscal authorities have a greater incentive to spend more today under fixed rates than under flexible rates; (3) in the presence of both factors above, fixed rates will induce more fiscal discipline only if the future punishment is sufficiently stronger than under flexible rates; and (4) neither fixed nor flexible rates could resolve the structural distortions caused by fragmented policymaking, and fiscal centralization needs to be undertaken to strengthen fiscal discipline.
Subject: Budget planning and preparation, Conventional peg, Exchange rate arrangements, Government asset and liability management, Inflation
Keywords: exchange rate, WP
Pages:
31
Volume:
2003
DOI:
Issue:
078
Series:
Working Paper No. 2003/078
Stock No:
WPIEA0782003
ISBN:
9781451850123
ISSN:
1018-5941
