| Countries with fixed exchange rates face a dilemma whenever they need to implement a stabilization plan. Should they keep the fixed exchange rate and tighten fiscal policy, or should they allow their currencies to float and inflation to rise? Whatever the final outcome, there seems to be a significant lag between the time when stabilization is first required and when it is finally implemented. Disagreement over the nature of stabilization is crucial to explain the sequence of events leading to a currency crisis. It affects agents' expectations about the future and may result in inefficient delay. This dissertation investigates the role that the interaction between independent monetary and fiscal authorities on the one hand, and between these and private agents on the other, plays in determining the timing and nature of a stabilization plan in a country with a fixed exchange rate.; Specifically, after a negative fiscal shock, new means of revenue need to be created. Delay is the result of a war of attrition between the fiscal and the monetary authority. The fiscal authority keeps large deficits in the hope that the monetary authority will monetize part of it. The monetary authority avoids monetization and keeps the peg as long as possible in the hope that the fiscal authority will reduce the deficit. If no agreement is reached, the deficit is financed by additions to the stock of public debt, which creates larger revenue needs in the future. Delay is therefore costly, as it implies larger future taxes. Uncertainty about future policies generates inflation expectations by households. Thus, delay results in real exchange rate appreciation and current account deficits, with consumption booms and inflation before stabilization regardless of its eventual nature. The behavior of the economy after stabilization depends on the adjustment implemented.; These predictions are consistent with some robust empirical regularities observed for many countries in the period leading to the end of the peg. The only case where none of these regularities are observed is France in the 1992 crisis of the EMS. In this case, the evidence is consistent with an immediate non-inflationary adjustment as predicted by the model. |
