This project studies a number of interrelated issues in government finance, the economics of currency crises, the sustainability of government debt, the behavior of fiscal policy in developing countries, and the fiscal theory of the price level.
Although the effects of the real exchange rate on government finance are significant, they have been neglected in the literature. The literature recognizes the importance of the real exchange rate through so-called balance sheet effects, i.e. the effect of real exchange rate movements on the valuation of existing government debt. However, the literature has mostly neglected the impact of the real exchange rate on the flows (the primary fiscal balance) via which the government finances its debt. The project argues, first, that the effects of the real exchange rate on the primary balance are significant in emerging markets, and are important in understanding the dynamics of currency crises. The project seeks to advance the theory of currency crises in order to capture these effects. The project also seeks to link the literature on currency crises and government debt sustainability (or fiscal sustainability) by incorporating the effects of the real exchange rate within standard fully-specified stochastic models of the business cycle in small open economies. These extensions to the literature should allow economic theory to explain the limitations on government borrowing in emerging markets, the procyclicality of fiscal policy in emerging markets (the tendency of the government to exacerbate rather than smooth the effects of the business cycle), and the pricing of nominal debt securities. Finally, the proposed research seeks to expand the nascent links between the literatures on currency crises, fiscal sustainability analysis and the fiscal theory of the price level, by showing how the latter can be seamlessly incorporated into standard models that are used in the former types of analysis.
This research will have a broad impact, in part, because it brings diverse areas of research in macroeconomics into greater contact with one another. So it should enhance synergies across sub-disciplines. The subject matter, currency crises and fiscal sustainability, is highly topical and important in the public policy arena. So this work has the potential to have a significant impact on how policy makers think about government debt, the functioning of fiscal policy, and the causes and consequences of currency crises. The investigator has recently developed a learning module on fiscal sustainability for the World Bank. This has been successful in disseminating knowledge about the subject matter to economists living and working in a wide range of countries. Through this type of channel, similar benefits, not necessarily affiliated with the World Bank, might be expected to emerge from the current project.
