Fiscal Dominance, Debt, and Exchange Rates

Abstract

Fiscally weak governments may prefer to reduce through devaluation the real value of their domestic financial obligations, rather than adjusting the fiscal deficit in order to keep servicing their debt. If the public anticipates this possibility, within a flexible exchange rate system, lose fiscal policies provoke exchange rate depreciations, while efforts to bring the deficit under control have the opposite effect. This interpretation contrasts with conventional views on the impact of fiscal expansions. The paper applies this "fiscal approach" to exchange rates to two alternative models of exchange rate dynamics in a small open economy, and analyzes some policy implications.

JEL Classification: 4312, 3200