FISCAL DISCIPLINE AND THE CHOICE OF EXCHANGE-RATE REGIME

The conventional wisdom claims that fixed exchange rates provide more fiscal discipline than do flexible rates, but the recent experience in Europe, the record of Sub-Saharan countries in the 1980s and the hist ory of stabilization attempts in Latin America cast empirical doubts o n this wisdom. We present a standard intertemporal model with perfect capital mobility and price flexibility in which fiscal policy is endog enously determined by a maximizing fiscal authority. The model shows t hat the difference between regimes lies in the intertemporal distribut ion of the costs of fiscal laxity. Fixed rates push these costs into t he future, while flexible rates allow the effects of unsound fiscal po licies to manifest themselves immediately through movements in the exc hange rate. Which system provides more discipline depends on the autho rities' discount rate.