EXCHANGE RATE-BASED STABILIZATION WITH ENDOGENOUS FISCAL RESPONSE

This paper studies the dynamics of inconsistent exchange rate-based st abilization policy-a policy that fixes the exchange rate without an un derlying fiscal adjustment to ensure that the exchange rate policy is sustainable in the long run-in a model where the perception that excha nge rate policy temporarily leads to an initial expansion in consumpti on that generates an increase in tax revenues large enough to eliminat e the ex-ante fiscal deficit. Therefore an ex-ante inconsistent stabil ization program displays, ex-post, all the features of a fiscally cons istent one; i.e., a fixed exchange rate and no fiscal deficit. in cont rast to the standard results, where the inconsistency between fiscal a nd exchange rate policy leads to a steady loss of international reserv es and culminates in a 'Krugman type' balance of payments crisis, this model predicts that along the path towards the balance of payments cr isis the economy displays no fiscal deficit and enjoys increasing inte rnational reserves. (C) 1997 Elsevier Science B.V.