Working Paper: CEPR ID: DP2929
Authors: Giancarlo Corsetti; Bartosz Mackowiak
Abstract: This Paper proposes a new framework for interpreting a currency crisis associated with a fiscal imbalance, which we find appropriate for the analysis of contemporary economies with outstanding public debt. Unlike the first-generation literature on speculative attacks, we do not assume that money growth finances the imbalance and that governments face exogenous borrowing constraints. In our model, the cause of a devaluation is a fiscal policy switch, from a policy-backing government debt fully with taxes, to one using taxes and unanticipated inflation. Its timing depends on the interaction of fiscal and monetary policy, where the latter is modelled in terms of interest rate rules. Real debt acts as leverage, and the rate of devaluation is smaller when nominal liabilities are a larger fraction of the total. The focus of our analysis of currency crises is on currency of denomination and maturity of government debt; the government's willingness to tolerate high interest rates; the possibility of coordination problems among holders of government debt.
Keywords: currency crisis; fiscal theory of the price level; speculative attack
JEL Codes: E58; F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| shift in fiscal policy (E62) | currency devaluation (F31) |
| fiscal policy (E62) | exchange rate (F31) |
| monetary policy (E52) | inflation post-devaluation (F31) |
| nominal liabilities (G32) | rate of currency depreciation (F31) |
| real debt (H63) | delay devaluation (F31) |
| coordination problems among debt holders (G33) | self-fulfilling runs (E44) |
| expectations about fiscal policy (E62) | currency crises (F31) |