Recent debates have focused on concerns that a European monetary union may entail an unacceptable loss of national governments' ability to stabilize their economies through monetary policy and constrain their use of inflation to raise revenues. In Discussion Paper No. 631, Gabriel De Kock and Research Fellow Vittorio Grilli assess the second critique by considering policy-makers' choice between distortionary income taxation and seigniorage to finance an exogenously given expenditure stream under alternative exchange rate systems: a pure float, fixed exchange rates with possible realignments, and full monetary union. In a monetary union there can be no inflation tax; under a pure float, the authorities have full flexibility to use it; under an adjustable peg such as the EMS devaluations entail `surprise inflation', enabling governments to levy lump-sum taxes on their outstanding nominal liabilities.

De Kock and Grilli find that there is no possible unambiguous ranking of the three regimes. A free float provides revenue flexibility which is most desirable when there is considerable uncertainty about future financing needs. A monetary union may nevertheless outperform a free float and an `EMS-type' regime under many circumstances, so criticisms of EMU based on budgetary considerations may be ill founded.
De Kock and Grilli note that much research on exchange rate regimes assumes that countries make irrevocable decisions to operate either a floating or a fixed rate regime; in practice the last hundred years have seen many switches from fixed to flexible exchange rate regimes and vice versa. The literature on `speculative attacks' views such switches as the outcome of incompatible monetary and exchange rate policies. It focuses on the dynamics of the forced abandonment of a fixed exchange rate and offers neither analysis of the motives that give rise to such policies nor any justification for fixed exchange rate policies. It therefore offers no insight into the welfare consequences of such regime switches.

De Kock and Grilli suggest that their model of the adjustable peg can reconcile the establishment and collapse of exchange rate regimes with the pursuit of rational government policies. Superficially inconsistent policies form part of a more complex regime in which the policy-maker, in well-defined circumstances, is allowed an excusable default on the commitment to a fixed exchange rate; this allows unusually large government spending needs to be met by devaluation, which imposes a lump-sum tax on the government's nominal liabilities. They cite historical experience to support this interpretation: fixed rate regimes tended to collapse during periods of suddenly rising public expenditures, while returns to pegged exchange rates typically coincided with the return of expenditure to normal levels.

Fiscal Policies and the Choice of Exchange Rate RegimeGabriel De Kock and Vittorio Grilli

Discussion Paper No. 631, March 1992 (IM)