Discussion Paper Details

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Title: Fiscal Devaluations

Author(s): Emmanuel Farhi, Gita Gopinath and Oleg Itskhoki

Publication Date: December 2011

Keyword(s): competitive devaluation, currency union and fiscal policy

Programme Area(s): International Macroeconomics, International Trade and Regional Economics and Public Economics

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, a value-added tax increase and a uniform payroll tax reduction. When the devaluations are anticipated, these policies need to be supplemented with a consumption tax reduction and an income tax increase. 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.

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Bibliographic Reference

Farhi, E, Gopinath, G and Itskhoki, O. 2011. 'Fiscal Devaluations'. London, Centre for Economic Policy Research.