Budget Deficits and Exchange-Rate Crises

Abstract

This paper investigates currency crises in an optimizing general equilibrium model with overlapping generations. It is shown that a rise in government budget deficits financed by future taxes generates a decumulation of external assets, leading up to a speculative attack and forcing the monetary authorities to abandon the peg.

Keywords:

• Budget deficits
• foreign exchange reserves
• currency crises

JEL CLASSIFICATIONS :

• F31
• F32
• F41
• E52
• E62

Acknowledgements

The authors are very grateful to two anonymous referees for their extremely useful suggestions. The authors also wish to thank Fabio C. Bagliano, Marianne Baxter, Leonardo Becchetti, Anna Rita Bennato, Lorenzo Bini Smaghi, Giancarlo Corsetti, Andrea Costa, Alberto Dalmazzo, Bassam Fattouh, Laurence Harris, Fabrizio Mattesini, Pedro M. Oviedo, Alessandro Piergallini, Cristina M. Rossi, Pasquale Scaramozzino, Salvatore Vinci and participants at the II RIEF Conference on International Economics and Finance – University of Rome ‘Tor Vergata’ for helpful comments on previous versions of this paper. The financial support of the MIUR (Grant No. 2007P8MJ7P_003) is gratefully acknowledged. The usual disclaimer applies.

Notes

¹The partition between first and second generation models is consistent with the classification scheme of currency crises proposed by Flood and Marion (1999), and Jeanne (2000). From this point of view, the so-called ‘third-generation’ models, elaborated to explain the more recent financial turmoils in Asia, Latin America and Russia, are considered extensions of the existing setups that explicitly include the financial side of the economy.

²This distinction may be found, for example, in Turnovsky (1977, 1997) and Obstfeld and Stockman (1985).

³For an exhaustive overview of the economic fundamentals in Asian countries in the years preceding the financial and currency crisis, see Corsetti et al. (1999) and World Bank (1999).

⁴Similar implications are also found in Cook and Devereux (2006).

⁵The approach of entering money in the utility function to allow for money holding behavior within a Yaari–Blanchard framework, is common to a number of papers including Spaventa (1987), Marini and van der Ploeg (1988), van der Ploeg (1991), and Kawai and Maccini (1990, 1995). Similar results could also be obtained by use of cash-in-advance models (see Feenstra, 1986). For a Yaari–Blanchard model with cash-in-advance, see Petrucci (2003).

⁶Following Blanchard (1985), this condition ensures that consumers are relatively patient, in order to ensure that the steady state-level of aggregate financial wealth is positive.

⁷This assumption ensures that savings are decreasing in wealth and that a steady-state value of aggregate consumption exists. See Blanchard (1985) for details.

⁸Similar fiscal rules are frequently adopted in the literature. See Benhabib et al. (2001) among others.

⁹However, for δ=0 model stability requires that β=i*.

¹⁰The effects of government deficit in optimizing models can be found, for example, in Frenkel and Razin (1987), Obstfeld (1989), Turnovsky and Sen (1991).

¹¹It can be easily shown that if δ=0, the long-run effects of the fiscal expansion will simply be: . That is because when the probability of death is equal to zero, the Ricardian equivalence is restored and the time profile of lump-sum taxes does not affect consumption. In such circumstances a tax cut will not give rise to any current account imbalances and to any change in demand for real money balances, that is why the currency crisis will not take place.

¹²Strong empirical support for a positive relationship between the current account deficit and current and expected future budget deficits is found by Piersanti (2000). See Baxter (1995) for a more general discussion on this issue.

¹³Clearly, since movements in fundamentals and hence the speculative attack are predictable in this model, the government could avoid the sharp loss in reserves by abandoning the peg just before the attack. However, if the government did so, then speculators would incorporate this into their strategies, so introducing strategic interactions and uncertainty into the time of collapse. We do not consider these issues here, which would terribly complicate the model and make it intractable (as there is no equilibrium in pure strategies) without adding anything new to the Pastine's (2002) results; nor we consider the optimal exit time issue as in Rebelo and Végh (2006), which nonetheless also involves strategic interactions. We simply focus on the less intricate and narrow target of describing the macroeconomic adjustment path associated with a consistent and more flexible policy rule – in contrast to those considered in the existing literature – which gives rise to the possibility, but not the certainty, of a currency crash, i.e., on the conditions for an attack.

¹⁴Recall that under under the floating regime all the observed variations in the level of real money balances are only due to changes in the exchange rate.

¹⁵Letting Z* denote the critical level of the tax cut above which the peg will collapse, it can be easily shown that .

¹⁶Letting be the critical stock of reserves below which the crisis will occur, we have that

¹⁷ Figures 1–4 illustrate a numerical example based on the following parametrization: i*=0.03, η=0.25, δ=0.02, α=0.04, Y=1, G=D ₀=0, [Stilde]=1, F ₀=0.5 and R ₀=0.2. The rate of time preference, β=0.024, and the initial stock of nominal money balances, M ₀=8.46, are implied. The fiscal expansion consists of an increase in Z of 0.05 from zero.

¹⁸This result is consistent with the evidence that in most Asian countries, during the years preceding the crisis, fiscal imbalances were either in surplus or in modest deficit. See World Bank (1999).