TY  - JOUR
AU  - Tornell,Aaron
AU  - Velasco,Andres
TI  - Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 5108
PY  - 1995
Y2  - May 1995
UR  - http://www.nber.org/papers/w5108
L1  - http://www.nber.org/papers/w5108.pdf
N1  - Author contact info:
Aaron Tornell
Department of Economics
UCLA
405 Hilgard Ave, Bunche Hall #8283
Los Angeles, CA  90095-1477
Tel: 310/794-1686
Fax: 310/825-9528
E-Mail: tornell@econ.ucla.edu

Andres Velasco
Columbia University
School of International and Public Affairs
420 West 118th Street
New York, NY 10027
Tel: 212/854-3899
E-Mail: avbranes@gmail.com
AB  - In recent years the conventional wisdom has held that fixed rates provide more fiscal discipline than do flexible rates.  In this paper we show that this wisdom need not hold in a standard model in which fiscal policy is endogenously determined by a maximizing fiscal authority.  The claim that fixed rates induce more discipline stresses that sustained adoption of lax fiscal policies must eventually lead to an exhaustion of reserves and thus to a politically costly collapse of the peg.  Hence, under fixed rates bad behavior today leads to punishment tomorrow.  Under flexible rates bad behavior has costs as well.  The difference is in the intertemporal distribution of these costs: flexible rates allow the effects of unsound fiscal policies to manifest themselves immediately through movements in the exchange rate.  Hence, bad behavior today leads to punishment today.  If fiscal authorities are impatient, flexible rates - by forcing the costs to be paid up-front - provide more fiscal discipline and higher welfare for the representative private agent.  The recent experience of Sub- Saharan countries supplies some preliminary evidence that matches the predictions of the model.
ER  -