Working Paper: CEPR ID: DP87
Authors: Sweder van Wijnbergen
Abstract: The analysis focuses on the government budget constraint and the resolution of inconsistent implications of different policy instruments under that constraint. We show how, under floating exchange rates, external shocks or internal structural reforms may cause jumps in inflation and the exchange rate through their impact on the government budget. In order to achieve a sustainable reduction in inflation an exchange rate freeze or crawling peg is shown to require restrictions not only on domestic credit, but also on the rate of increase in interest-bearing public debt. We endogenize regime collapse by introducing rational speculation against the central bank, and show that if an exchange rate freeze collapses, post-collapse inflation will exceed the rate prevailing before the freeze started.
Keywords: monetary policy; fiscal policy; open economies; inflation; exchange rate freeze; crawling peg; government budget constraint
JEL Codes: 134; 321; 431
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government budget constraints (H60) | inflation (E31) |
| government budget constraints (H60) | exchange rates (F31) |
| external shocks (F69) | inflation (E31) |
| external shocks (F69) | exchange rates (F31) |
| fiscal deficits (H68) | inflation (E31) |
| fiscal deficits (H68) | exchange rates (F31) |
| exchange rate freeze (F31) | restrictions on domestic credit (E51) |
| exchange rate freeze (F31) | growth rate of public debt (H63) |
| exchange rate freeze collapses (F31) | post-collapse inflation (E31) |
| restrictive monetary policies (E52) | depreciation (D25) |
| restrictive monetary policies (E52) | higher inflation (E31) |