Working Paper: NBER ID: w17662
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 dynamic New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions- producer or local currency pricing, along with nominal wage stickiness; under arbitrary degrees of asset market completeness and for general stochastic sequences of 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 are revenue neutral. 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: Fiscal Policy; Exchange Rate; Devaluation; New Keynesian
JEL Codes: E32; E60; F30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| uniform increase in import tariffs and export subsidies (F13) | replicate effects of nominal exchange rate devaluation (F31) |
| increase in value-added taxes and reduction in payroll taxes (H25) | replicate effects of nominal exchange rate devaluation (F31) |
| fiscal policies (H30) | changes in real allocations and nominal prices (E39) |
| anticipated devaluations (F31) | consumption tax reduction and income tax increase (H29) |
| application of all proposed tax instruments (H29) | fiscal devaluation remains government revenue neutral (H29) |
| partial default on foreign bondholders (F34) | equivalence in some scenarios (C30) |