Fiscal Discipline and the Choice of Exchange Rate Regime

Aaron Tornell and Andrés Velasco

No 4004, Research Department Publications from Inter-American Development Bank, Research Department

Abstract: Conventional wisdom claims that fixed exchange rates provide more fiscal discipline than do flexible rates, but the recent experiences in Europe, the record of Sub-Saharan countries in the 1980s, and the history of stabilization attempts in Latin America cast empirical doubts on this wisdom. To explore this puzzle we present a standard intertemporal model with perfect capital mobility and price flexibility, in which fiscal policy is endogenously determined by a maximizing fiscal authority.

Date: 1994-09
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