Exchange Rate Management: Intertemporal Tradeoffs

The authors open from the premise that “exchange rates cannot be managed without the pursuit of other policies which make the entire package internally consistent,” so that a government’s exchange-rate commitment is only as credible as the monetary-fiscal measures that validate it ex post (Section 1, Introduction, citing Pollak 1957). Because those supporting measures “will typically be anticipated by economic agents during the initial periods of exchange rate management,” the paper’s goal is to characterize “the intertemporal constraints on exchange rate management for economies in which governments precommit themselves to the future course of monetary and fiscal policies and honor their commitments,” tracing out the resulting effects on the time pattern of spending and debt.

The paper deliberately breaks Ricardo-Barro debt neutrality by modeling consumers with finite expected lifetimes, following Blanchard (1984): a cohort of size 1 is born each period and survives to the next with constant, age-independent probability γ, so foreign lenders charge a risk-adjusted interest rate R/γ rather than the safe rate R (Section 2). The authors are explicit about why this matters: “It is known that in the presence of Ricardo-Barro type neutrality exchange rate management has no real effects (see, for example, Helpman and Razin (1979))” – the earlier infinite-horizon result – but here, “this neutrality breaks down” not because of distortions (which the paper deliberately avoids) but because individuals who may die “cannot be expected” to fully internalize the government’s intertemporal budget constraint, so “the time pattern of taxes required in order to manage the exchange rate will generally have real effects.”

Under a free float, the government injects and withdraws money purely through lump-sum taxes/transfers θ_t, and the paper shows directly that monetary injections and withdrawals via θ_t have no real effects on the path of consumption, debt, or the real exchange rate (Eq. 2, Section 2) – “this result is in line with models in which there are no overlapping generations and individuals live to the end of the economy’s horizon (see Helpman (1981)).” The authors flag that this neutrality is itself fragile: it “need not hold in the presence of a labor-leisure choice or externally financed investment,” nor if the buyer’s rather than the seller’s currency is used for transactions (citing their own 1984 paper), nor if dividends are not divided equally among all living individuals – “if this is not so, and individuals can take loans using current period output as collateral…then monetary policy will have real effects.”

The paper derives the unique tax sequence θ_t = e_t·y(ρ_t) − ē·y(ρ̄_t) (Eq. 3) that must accompany any given exchange-rate path {e_t} to leave real variables exactly at their floating-rate benchmark values. The authors contrast this sharply with the earlier representative-agent result: “while in previous models (e.g. Helpman (1981)) there was no constraint on the time pattern of the neutral taxes but only on their present value, here this pattern is unique” (Section 3) – because overlapping generations care about when in their own lifetime a tax or transfer arrives, not merely its discounted sum, the government cannot substitute one time profile of taxes for another with the same present value and expect the same real outcome. The authors add a practical observation: “even when the exchange rate is maintained constant over time, varying taxes and transfers are required as long as the real exchange rate is not constant over time. Hence, exchange rate management without real consequences requires a well coordinated time-varying policy of monetary injections and withdrawals. No such policy is required under a free float.”

If the neutral tax rule (Eq. 3) is not followed, the shortfall shows up as reserve movements (public external debt), which the paper shows “have real effects and that these effects depend on the time pattern of reserve movements. Different time patterns of reserves generate different redistributions of wealth across generations” (Section 3, Eq. 10-11). The mechanism operates through an individual’s real wealth, which depends both on when future exchange-rate depreciations hit and on when future taxes are imposed: “an individual born at t is better off the further away in the future taxes are imposed and the exchange rate is depreciated, and the nearer in the future transfers are given and the exchange rate is appreciated.” At the moment policy begins, the initial reserve change decomposes exactly into an unanticipated capital gain on money balances (k, from the surprise appreciation) minus an unanticipated increase in real tax liabilities (h): b₀ = g = k − h (Eq. 14), so the neutral policy (Eq. 3 at t=0) is precisely the one that sets the tax so the unanticipated tax increase equals the unanticipated capital gain.

In the worked illustration (Section 4), the exchange rate is frozen at ē below its pre-existing level ē₋₁ (an overvalued currency), with no taxes levied in period 0 and no taxes at all until period T, when a constant tax sufficient to service the accumulated foreign debt begins and continues forever. Because no offsetting tax is imposed when the appreciation occurs, there is a pure windfall g = k > 0 at t=0 (h=0), and the solved dynamics (Eqs. 23-24) show that “the initial overvaluation of the currency makes…higher spending level[s]…larger the later taxes are imposed, and that the eventually lower spending level is smaller the later taxes are imposed. Thus, the longer the delay in the required contractionary policy the larger are the real effects of exchange rate management.” Government foreign debt “grows at the rate of interest until period T−1 and remains constant afterwards” (Eq. 15), and while private foreign debt is lower throughout than in the benchmark, “a direct calculation shows that total debt…is larger than [the benchmark] in all time periods, which means that public debt increases by more than private debt declines.”

The authors state the intuition directly: “The capital gain from the overvalued currency is appropriated by the individuals who are alive in period zero. To them the present value of future tax liabilities is smaller than the capital gain, and they respond by raising spending in all periods. All future generations face larger tax liabilities and reduce spending; the later an individual is born the larger his tax liability in present value terms” (except that everyone born after period T−1 shares the same tax liability) (Section 4). Because “the population share of individuals who were alive at t=0 declines and the share of those with heavier tax liabilities increases” over time, aggregate spending is “initially larger and it becomes smaller far enough in the future” – exactly the twist in the spending profile and the permanent upward shift in debt that the paper’s abstract promises. The policy cannot delay taxation indefinitely, however: “the contractionary policy cannot be delayed at will, because given a limit on taxing capacity, say x percent of GNP…taxes which eventually have to equal [a fixed multiple of the windfall] cannot exceed x percent” of output.

The authors state that their results “are in line with the observed responses of spending and debt to the disinflation attempts in Israel during 1982-1983 and in Chile and Argentina during the late seventies” (Section 4) – all cases of exchange-rate-based stabilization with an initially appreciated real exchange rate followed by rising external debt. The paper frames the broader contrast as follows: “In our framework the time pattern of real variables does not depend on monetary policy if the exchange rate is freely floated and in this case the allocation of resources is efficient. Efficiency is also preserved when the exchange rate is managed, but the time pattern of real variables does depend on the policies that support the exchange rate path” (Section 1) – so the paper’s point is not that managed exchange rates are inefficient, but that they are not neutral across generations the way floating rates (or managed rates with a representative, infinite-horizon agent) are.

This summary is grounded in the paper’s own NBER working-paper draft (Working Paper No. 1590, March 1985), the direct precursor circulated two years before the March 1987 American Economic Review publication; the working paper’s own abstract and body match the published article’s argument and the AER’s own front matter for the issue (confirmed via JSTOR) lists the identical title, authors, and page range, so the two are treated here as the same paper under normal pre-publication revision.