DP8721 Fiscal Devaluations

Author(s):	Emmanuel Farhi, Gita Gopinath, Oleg Itskhoki
Publication Date:	December 2011
Keyword(s):	competitive devaluation, currency union, fiscal policy
JEL(s):	E32, E6, F3
Programme Areas:	International Macroeconomics, Public Economics, International Trade and Regional Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=8721

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.