Do Fixed Exchange Rates Induce More Fiscal Discipline?

Yan Sun

No 2003/078, IMF Working Papers from International Monetary Fund

Abstract: 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.

Keywords: WP; exchange rate (search for similar items in EconPapers)
Pages: 31
Date: 2003-04-01
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Citations: View citations in EconPapers (17)

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