Do Fixed Exchange Rates Induce More Fiscal Discipline?

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.
Publication date: April 2003
ISBN: 9781451850123
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Economics- Macroeconomics , Economics- Macroeconomics , Money and Monetary Policy , Money and Monetary Policy , Fiscal Discipline , exchange rate , fiscal authorities , exchange rate regime , fiscal authority , Macroeconomic Policy , Macroeconomic Aspects of Public Finance , and General Outlook: General , Open Economy Macroeconomics

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