Exchange-Rate-Based Stabilization with Endogenous Fiscal Response

In the context of a perfect foresight, intertemporal optimizing, cash-in-advance model, this paper studies the dynamics of an inconsistent exchange rate-based stabilization policy that fixes the exchange rate without an underlying fiscal adjustment to ensure that the exchange rate policy is sustainable in the long run. The perception that the exchange rate policy is temporary leads to an initial expansion in consumption, and, since the model allows for distortionary taxes on consumption, to an endogenous increase in tax revenues large enough to eliminate the ex-ante fiscal deficit. This paper was prepared for the 8th NBER Inter-American Seminar, held in Bogotá, Colombia in November 1995.