A Fiscal Theory of Currency Crises

Betty Daniel ()

No 535, Econometric Society World Congress 2000 Contributed Papers from Econometric Society

Abstract: This paper presents a fiscal theory of exchange rate crises. When the fiscal authority allows the present value of primary surpluses inclusive of seigniorage to differ from the current real value of government debt at the pegged exchange rate and a constant expected future interest rate, then the pegged rate is no longer viable. According to the fiscal theory of the price level, the current exchange rate (equivalently the price level) and the price of long-term government bonds, must equate the real value of government debt and the present value of primary surpluses. In the absence of long-term government bonds, the exchange rate must do the job, and collapse is instantaneous with the change in the present value of primary surpluses. In the presence of a sufficient quantity of long-term bonds, the price of long-term bonds can adjust the real value of government debt, and the collapse can be delayed. Whether collapse is instantaneous or delayed is at the discretion of the monetary authority. The paper shows that while fiscal policy is responsible for generating the crisis, monetary policy is responsible for its characteristics. These include the timing of the crisis and the magnitude of the collapse- period depreciation. This is a fundamentals theory of exchange rate crises. However, the theory shifts the focus for the cause of collapse away from monetary policy toward fiscal policy. And it demonstrates that fundamentals-generated collapse need not occur following a sustained period of policy misalignment and reserve loss. It can explain other types of exchange rate crises, including those, which surprise markets, as with the ERM crises in 1993, and crises caused by expectations of future fiscal expenditures with no sustained reserve loss, as in the Southeast Asian crises of 1997.

Date: 2000-08-01
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Journal Article: A Fiscal Theory of Currency Crises (2001)
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