Working Paper: CEPR ID: DP1899
Authors: Matthew B. Canzoneri; Robert E. Cumby; Behzad T. Diba
Abstract: This paper explores the implications of a new theory of price determination (due to Leeper, Woodford and Sims) for the maintenance of various exchange rate systems ? crawling pegs, fixed pegs, and common currency areas. It shows that deeper monetary integration requires more fiscal discipline, especially if price stability is an objective; these monetary arrangements cannot be achieved by monetary policy alone, as conventional wisdom would seem to suggest. A particularly striking result is that a currency peg is simply not sustainable if fiscal surpluses are determined by an exogenous political process; maintenance of a fixed currency peg requires the government to guarantee fiscal solvency for any equilibrium sequence of prices (which Woodford calls a Ricardian Regime). Interestingly, the debt and deficit constraints that were written into the Maastricht Treaty, and will continue in the Stability Pact after EMU, are examples of the fiscal discipline that is required.
Keywords: exchange rate regimes; fiscal discipline; price determination
JEL Codes: E31; F33; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Deeper monetary integration (F36) | Greater fiscal discipline (E62) |
| Nature of fiscal policy (E62) | Viability of fixed exchange rates (F31) |
| Fiscal dominant regime (E62) | Government's present value budget constraint determines price levels (H19) |
| Money dominant regime (E42) | Monetary authorities control price levels (E64) |
| Fiscal shocks (E62) | Price and exchange rate variations in FD regimes (F31) |