Do Fixed Exchange Rates Induce More Fiscal Discipline?

31 Pages Posted: 29 Jan 2006

See all articles by Yan Sun

Yan Sun

International Monetary Fund (IMF) - Western Hemisphere Department

Date Written: April 2003

Abstract

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.

Keywords: Fiscal Discipline, Exchange Rate Regimes

JEL Classification: E60, F41, F31

Suggested Citation

Sun, Yan, Do Fixed Exchange Rates Induce More Fiscal Discipline? (April 2003). IMF Working Paper, Vol. , pp. 1-31, 2003. Available at SSRN: https://ssrn.com/abstract=879154

Yan Sun (Contact Author)

International Monetary Fund (IMF) - Western Hemisphere Department ( email )

700 19th Street NW
Washington, DC 20431
United States

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