Fixed versus flexible exchange rates: Which provides more fiscal discipline?

Conventional wisdom holds that fixed rates provide more fiscal discipline t han do flexible rates. In this paper we show that this wisdom need not hold in a standard model in which fiscal policy is endogenously determined by a maximizing fiscal authority. The claim that fixed rates induce more discip line stresses that sustained adoption of lax fiscal policies must eventuall y lead to an exhaustion of reserves and thus to a politically costly collap se of the peg. Hence, under fixed rates bad behavior today leads to punishm ent tomorrow. Under flexible rates bad behavior has costs as well. The diff erence is in the intertemporal distribution of these costs: flexible rates allow the effects of unsound fiscal policies to manifest themselves immedia tely through movements in the exchange rate. Hence, bad behavior today lead s to punishment today. If fiscal authorities are impatient, flexible rates - by forcing the costs to be paid up-front - provide more fiscal discipline and higher welfare for the representative private agent. The recent experi ence of sub-Saharan countries supplies evidence that matches the prediction s of the model. (C) 2000 Published by Elsevier Science B.V. All rights rese rved.