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Exchange Rate Crises and Fiscal Solvency

By Betty Daniel

Abstract

This paper combines insights from generation-one currency crisis models and the Fiscal Theory of the Price Level (FTPL) to create a new generation-one type model. Fiscal solvency is the fundamental generating crises, as in generation-one models. The initial fixed-exchange-rate policy entails risks, both to its sustainability and to the real value of government debt. The risks are due to stochastic surplus shocks and an upper bound on the present value of surpluses. Stochastic surplus shocks, changes in expectations of future fiscal commitments, and changes in the policy parameters can raise current desired debt or reduce expected future surpluses. Should the government's desired debt exceed the present-value of expected future surpluses, agents refuse to lend into this position of insolvency. The sudden stop of capital inflows creates a crisis. Equilibrium can be restored with some combination of policy switching and debt devaluation to restore fiscal solvency. The model can explain a wider variety of crises than generation one models, including those involving sovereign default. It is applied to explain crises in Argentina (2001), Mexico (1994-95), and Southeast Asia (1997), which did not fit the stylized facts of generation one models.

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