Fiscal Imbalances and the Dynamics of Currency Crises

This paper builds a model in which a currency crisis is triggered by a “fiscal imbalance” – a current or anticipated future decline in the present value of the government’s real primary surpluses – and studies how the size and maturity structure of the government’s outstanding nominal liabilities, rather than the size of the fiscal gap alone, determine whether and for how long a fixed exchange rate can be defended before it collapses. In a baseline economy where the government holds only short-term nominal debt, the authors derive a “razor-edge” result: if the government tries to delay a devaluation to raise seigniorage revenue after the collapse, the present value of that seigniorage exactly offsets the fiscal cost of defending the peg beforehand (the revenue lost to the pre-collapse contraction in money demand), leaving the net present value of seigniorage equal to zero – so financing a fiscal imbalance through money creation and delaying the exchange-rate adjustment turn out to be mutually inconsistent goals, and with only short-term debt outstanding the peg must break immediately, with the size of the initial devaluation pinned down by the fiscal imbalance and the stock of outstanding money and bonds. Once the model is extended to include long-term, non-indexed government bonds (perpetuities), a different channel opens: news of a future fiscal imbalance causes an immediate, unanticipated fall in the price of those bonds, transferring wealth from private bondholders to the government exactly as an unexpected devaluation would, which can let the government postpone the collapse of the peg for a time even when the net present value of seigniorage is zero, provided the outstanding stock of long-term liabilities is large enough. Government solvency alone leaves the exact date of a delayed collapse indeterminate within a finite window; adding a monetary policy rule under which the central bank defends the peg only as long as the domestic interest rate stays below some threshold pins the timing down uniquely, via a backward-induction argument analogous to Krugman’s (1979) classic model but expressed in terms of an interest-rate rather than a reserve-based defense criterion. The paper also shows that when investors can trigger a self-fulfilling run on the government’s short-term debt – a coordination failure distinct from the fiscal mechanism – the exact timing of collapse becomes genuinely indeterminate and unpredictable even though the underlying fiscal imbalance still bounds how long the peg can possibly survive. Framed explicitly as an extension of the fiscal theory of the price level to a currency-crisis setting, and as a bridge to first-generation, Krugman-style crisis models, the paper’s authors are careful to note that a precisely zero net seigniorage result is a feature of their specific model, but argue the underlying lesson – that the fiscal costs of peg defense constrain what seigniorage policy can actually achieve – is more general.

Giancarlo Corsetti | Macro Paper Warehouse

Fiscal Imbalances and the Dynamics of Currency Crises