Fiscal Devaluations

56 Pages Posted: 22 Dec 2011

See all articles by Emmanuel Farhi

Emmanuel Farhi

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Gita Gopinath

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Oleg Itskhoki

Princeton University - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: December 2011

Abstract

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 standard New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions -- producer or local currency pricing, along with nominal wage stickiness; under alternative asset market structures, and for anticipated and unanticipated 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 have zero impact on fiscal revenues. 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.

Keywords: competitive devaluation, currency union, fiscal policy

JEL Classification: E32, E6, F3

Suggested Citation

Farhi, Emmanuel and Gopinath, Gita and Itskhoki, Oleg, Fiscal Devaluations (December 2011). CEPR Discussion Paper No. DP8721. Available at SSRN: https://ssrn.com/abstract=1976062

Emmanuel Farhi (Contact Author)

Harvard University - Department of Economics ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Gita Gopinath

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Oleg Itskhoki

Princeton University - Department of Economics ( email )

Fisher 306
Princeton, NJ 08544-1021
United States
+1 (609) 258-5493 (Phone)

HOME PAGE: http://www.princeton.edu/~itskhoki

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