Essays on Exchange-Rate-Based Stabilization Under Fiscal Constraints

Exchange-rate-based inflation stabilization programs cause a sizable loss of inflation tax revenue and thus open a fiscal gap. The stabilization literature usually assumes that this gap can be closed by raising lump-sum (nondistortionary) taxes and/or cutting lump-sum transfers. As such policies are difficult to implement in practice, these two essays analyze two alternatives. The first essay explores the implications of raising a conventional income tax to make up for the loss of inflation tax revenue in the context of an exchange-rate-based stabilization program in an open economy with sticky prices and monopolistic competition. The combination of smaller monetary and larger tax distortion in the low-inflation steady state results in lower consumption and output of nontradable goods than in the high-inflation equilibrium. In addition, the recession accompanying the transition to the low-inflation steady state produces welfare losses. Nevertheless, the net welfare result is a gain, as larger money balances and more leisure time outweigh the cost of lower consumption. The essay also explores the sensitivity of this welfare trade-off to various structural characteristics of the economy and exogenous factors. The second essay assumes that both tax and spending policies are inflexible and looks instead at the role of monetary policy in closing the emerging fiscal gap. It shows that in a closed economy a monetary expansion can lower the real interest rate. This benefits the budget both by generating a money demand boom, which expands the base of the inflation tax, and by lowering the budget's interest payments. These effects are, however, dependent on the credibility of the stabilization program, as the same-size monetary expansion fails to achieve fiscal sustainability when credibility is lacking.