Working Paper: CEPR ID: DP8721
Authors: Emmanuel Farhi; Gita Gopinath; Oleg Itskhoki
Abstract: We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a standard New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions -- producer or local currency pricing, along with nominal wage stickiness; under alternative asset market structures, and for anticipated and unanticipated devaluations. There are two types of fiscal policies equivalent to an exchange rate devaluation -- one, a uniform increase in import tariff and export subsidy, and two, a value-added tax increase and a uniform payroll tax reduction. When the devaluations are anticipated, these policies need to be supplemented with a consumption tax reduction and an income tax increase. These policies have zero impact on fiscal revenues. In certain cases equivalence requires, in addition, a partial default on foreign bond holders. We discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.
Keywords: Competitive Devaluation; Currency Union; Fiscal Policy
JEL Codes: E32; E6; F3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in import tariffs and export subsidies (F14) | same real allocations as nominal exchange rate devaluation (F31) |
| increase in value-added taxes and reduction in payroll taxes (H25) | mimic effects of nominal devaluation (F31) |
| anticipated devaluations need consumption tax reduction and income tax increase (E69) | fully replicate real allocations (C59) |
| fiscal policy adjustments (E62) | debt obligations (partial default on foreign bondholders) (F34) |