Fiscal Devaluations

Date Published:

Abstract:

We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a standard New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions—producer or local currency pricing, along with nominal wage stickiness; under alternative asset market structures, and for anticipated and unanticipated devaluations. There are two types of fiscal policies equivalent to an exchange rate devaluation—one, a uniform increase in import tariff and export subsidy, and two, an increase in value-added tax and a uniform reduction in payroll tax. When the devaluations are anticipated, these policies need to be supplemented with a reduction in consumption tax and an increase in income taxes. These policies have zero impact on fiscal revenues. In certain cases equivalence requires in addition a partial default on foreign bond holders. We discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.

Notes:

Co-author Emmanuel Farhi is a professor of economics at Harvard University. Co-author Oleg Itskhoki is a professor of economics at Princeton University.