Fiscal Deficits, Exchange Rate Crises and Inflation

This paper extends earlier work on unsustainable monetary policies by endogenizing the regime switch that ultimately restores sustainability. Within this framework we analyse exchange rate based stabilization programmes and show how constraints on Central Bank borrowing during an exchange crisis influence timing and nature of the post-collapse equilibrium. Such constraints introduce non-neutralities; more restrictive pre-collapse credit policies increase the post-collapse inflation rate. External shocks can destroy consistency between fiscal programmes and inflation targets, causing reserve losses, exchange rate changes and higher inflation. Balance of Payments crises are the mechanism through which fiscal imbalances translate into higher inflation rather than an alternative explanation of it. This paper deals with inflation, fiscal deficits and exchange rate policy in high-inflation countries. The experience of the past decade has presented a series of puzzles. For example, countries attempting to stabilize inflation through an exchange rate freeze often saw inflation accelerate after the collapse of the experiment to levels well above those observed before the programme was implemented. Another puzzle concerns the relation between inflation and Balance of Payments crises. In many countries, a BoP crisis forcing a change in exchange rate policy often led to a persistent increase in inflation (Liviatan and Piterman (1984)). This has led to doubts about the relevance of fiscal deficits in explaining inflationary episodes, leading many to see BoP crises as an independent explanation of inflation. But this apparent relation is a puzzle; a BoP crisis cum devaluation can at most explain a jump in the price level, but not a sustained increase in inflation. In this paper we demonstrate that these puzzles can be explained fully by drawing on the public finance approach to inflation initiated by Phelps (1973). Thus the fiscal versus BoP controversy is not a real one; our analysis shows that BoP crises and exchange rate shifts are part of the mechanisms through which fiscal imbalances translate into higher inflation, rather than alternative explanations. To make these points, we present a simple open-economy model to analyse the transition to a fixed exchange rate regime, discuss sustainability, and demonstrate what happens when policy measures are inconsistent and the fixed regime unsustainable. We also demonstrate how the constraints under which the Central Bank has to operate the exchange rate regime influence the timing of the attack, the post-collapse inflation rate and the effects of pre-collapse fiscal policy on the post-collapse equilibrium. The analysis builds on the work of Sargent and Wallace (1982) and Liviatan (1984) on unsustainable monetary policies (cf. Buiter (1988, 1989) and Drazen and Helpman (1987) for open economy variants). Contrary to this literature, we link the timing of the regime switch towards sustainable policies to rational speculative behaviour rather than assuming it to be exogenous. The introduction of rational speculators forcing a regime switch draws on the literature on speculative attacks on Central Bank reserves initiated by 8I