Fiscal Devaluations

Emmanuel Farhi, Gita Gopinath and Oleg Itskhoki

The Review of Economic Studies, 2014, vol. 81, issue 2, 725-760

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 dynamic New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions—producer or local currency pricing, along with nominal wage stickiness; under arbitrary degrees of asset market completeness and for general stochastic sequences of 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 are revenue neutral. 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.

Date: 2014
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Related works:
Working Paper: Fiscal Devaluations (2014)
Working Paper: Fiscal devaluations (2012)
Working Paper: Fiscal devaluations (2012)
Working Paper: Fiscal Devaluations (2011)
Working Paper: Fiscal Devaluations (2011)
Working Paper: Fiscal Devaluations (2011)
Working Paper: Fiscal Devaluations
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