Fiscal Discipline and Exchange Rate Regimes: Evidence From the Caribbean

May 1, 2006

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Rupa Duttagupta, and Guillermo Tolosa. Fiscal Discipline and Exchange Rate Regimes: Evidence From the Caribbean, (USA: International Monetary Fund, 2006) accessed December 21, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

This paper assesses the nature of fiscal discipline under alternative exchange rate regimes. First, it shows in a simple theoretical framework that fiscal agencies under a currency union with a fixed exchange rate can have the largest incentive to overspend or "free-ride" (compared to those under other exchange rate regimes) owing to their ability to spread the costs of overspending in terms of the inflation tax across both time-given the fixed exchange rate-and space-given the currency union. In contrast, such free-riding behavior does not arise under flexible regimes owing to the immediate inflationary impact of spending. Next, empirically, it shows that fiscal stances in countries with fixed pegs and currency unions regime demonstrate greater free-riding behavior than countries with more flexible regimes in 15 Caribbean countries during 1983-2004.

Subject: Conventional peg, Economic integration, Exchange rate arrangements, Fiscal policy, Fiscal stance, Foreign exchange, Monetary unions

Keywords: Aggregate government budget constraint, Budget constraint, Caribbean, Central bank, Common currency, Conventional peg, Currency unions, Dislike inflation, ECCU country, ECCU member, ECCU member country, Exchange rate, Exchange rate arrangements, Exchange rate case, Exchange rates, Fiscal policy, Fiscal stance, FPCU regime, Inflation cost, Monetary unions, Money growth, Utility function, WP

Publication Details

Pages:

37
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2006/119
Stock No:

WPIEA2006119
ISBN:

9781451863796
ISSN:

1018-5941

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