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Cochrane Fiscal Foundations of Monetary Regimes
Cochrane Fiscal Foundations of Monetary Regimes
Cochrane Fiscal Foundations of Monetary Regimes
•Commitment
•Rules (Taylor)
•Fiscal theory
Regimes
•Peg?
•Currency board?
•Dollarize?
•Float?
•Interest rate rule (Taylor)?
•Exchange rate rule?
•Banks lender of last resort?
•Borrow domestic or foreign?
Price level shows up in two places
And
Bt 1 M t 1
B f
t 1 Et j st j “Gov’t budget constraint” (2)
Pt j 0
Empirical example: 1997 Asia. Large prospective (not current) deficits led to crashes.
Bad loans, governments will bail out banks. Can’t (won’t) raise taxes.
→“Default’’ (via devaluation/inflation) on outstanding nominal debt.
Country Bad loan / Cost / Exch rate fall
Gov’t revenue GDP
Indonesia 66% 66% 85%
Korea 128% 24% 60%
Malaysia 79% 22% 40%
Phillippines 34% 35% 40%
Thailand 195% 40%
Hong Kong 18% 0%
Singapore 12% 15%
Source: Burnside, Eichenbaum, Rebelo JPE 2001
Fiscal roots: Could any open market operation (exchange money for nominal debt)
have saved East Asia 1997, Russia 1998, Argentina 2002? IMF view.
Note: danger of conventional accounting. Inflation tax not on books.
Korea “paid” for bank crisis by devaluing won salaries. (BER 2002).
Monetary regimes
Low High
Characteristics:
1. Own country fiat money (not dollarize, peg, gold standard, etc.)
2. Chronic high inflation
3. Legal restrictions to boost demand for base money
a) Currency controls, then trade controls (Hold M, not $)
b) Banking, finance, interest rate controls (Hold M, not bank deposits, stocks)
c) Anti- “hoarding”, “speculation” measures. (Hold M instead!)
d) Price controls, then quantity allocation
Occurs when tax < spending
a) Wars. (US too.)
b) Communist countries.
c) Developing countries.
Characteristics:
Fiat currency, floating exchange rate, large or closed economy.
Advantage:
1. Can, in principle, smooth real shocks
Difficulties:
1. (US) Must raise interest rate more than 1-1 with inflation
-Even in bad times – tempted always to “fight recession”
→Time consistency, rules, central bank independence, inflation targets,…
2. Theory a mess. Does it really stabilize inflation?
3. (Developing) Needs lots of fiscal slack.
- Fiscal equation is still there, tax/spend (s) must adjust to follow P.
- Example: Suppose central bank deflates.
Treasury must raise taxes to pay off outstanding nominal debt!
- Will not solve fiscal temptation to inflate (“default” on debt).
- Not an option for countries with intractable fiscal problems
Even if commitment problem is solved
Monetary regimes
Low High
Bt 1 M t 1
B f
t 1 Et j st j
Pt j 0
Low High