Academic journal article Economic Inquiry

Exchange Rate Regimes and Fiscal Discipline: The Role of Capital Controls

Academic journal article Economic Inquiry

Exchange Rate Regimes and Fiscal Discipline: The Role of Capital Controls

Article excerpt

I. INTRODUCTION

The influence of exchange rate regimes (ERRs) on fiscal discipline has long been debated in both academic environments and policy makers' circles. The theoretical literature discusses the influence of ERRs on fiscal discipline exploiting the classic dichotomy of fixed versus flexible ERRs and assuming perfect capital mobility. Conventional wisdom-represented by papers like Aghevli, Khan, and Montiel (1991) and Giavazzi and Pagano (1988)--emphasizes the strong disciplinary properties of fixed regimes by stressing the deterrent effect that the fear of fixed exchange rate collapse has over fiscal authorities. However, Tornell and Velasco (t 998, 2000) take issue with the previous view by considering political economy arguments. They argue that lax fiscal policies have political costs in terms of inflation under both regimes. The difference is the intertemporal distribution of these costs: under flexible regimes they manifest immediately through the exchange rate, while under fixed regimes they become evident only when the exhaustion of reserves makes the fixed regime collapse. If the fiscal authority is impatient, flexible regimes provide more fiscal discipline than fixed regimes by forcing the cost to be paid up-front. Empirical studies tend to support Tornell and Velasco's arguments (Tornell and Velasco 1998, 2000; Fatas and Rose 2001; Alberola and Molina 2004; Alberola, Molina, and Navia 2005).

A limitation of this literature is that it assumes perfect capital mobility, even though unrestricted capital flows seem to be the exception rather than the rule. Diverse forms of capital controls were pervasive until the mid-1990s (Reinhart and Rogoff 2004) and recently regained popularity to cope with massive capital inflows since the recent global financial crisis. The fact that even the International Monetary Fund (IMF)--presumably a bulwark of macroeconomic orthodoxy-has come out in favor of using tools such as Tobin taxes under some recent circumstances, illustrates the renaissance of capital controls in this much-changed post-Lehman world.

This paper contributes to the literature on the disciplining effect of ERRs for fiscal policy. It extends the argument of the effects of flexible and fixed ERRs on fiscal discipline--as described by Tornell and Velasco (1998, 2000)--by adding a third ERR: dual exchange rate regime. In a dual exchange rate system, there are both fixed and floating exchange rates in the market. The fixed rate is only applied to certain segments of the market, such as current account transactions (commercial exchange rate). In the meantime, the price of capital account transactions is determined by a market driven exchange rate (financial exchange rate). This type of capital control has been a recurrent tool used by countries when trying to avoid a depreciation on domestic prices while maintaining some degree of control over the capital account and international reserves (Guidotti and Vegh 1992). Indeed, using the Reinhart and Rogoff (2004) ERR classification, we find that more than 35% of countries had dual regimes during the 1970s and 1980s and about 20% still had them in the 1990s and 2000s (Figure 1). These figures reach about 45% and 30%, respectively, for the developing world.

What are the consequences of running lax fiscal deficits under dual ERRs? Similar to fixed and flexible ERRs under perfect capital mobility, unsound fiscal policies increase future anticipated monetization, consequently reducing desired future money holdings. The latter change creates excess demand for foreign bonds which, because of the presence of dual exchange rates, depreciates the financial exchange rate and reduces the current domestic real interest rate. This last factor increases current consumption, augmenting the current account deficit. In other words, this capital control enables to maintain temporarily low inflation rates like fixed regimes, since the commercial exchange rate is assumed to be fixed, but it also boosts current consumption as private agents attempt to reduce their real balances because of the expected inflation tax. …

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