Exchange Rate-Based Stabilization with Endogenous Fiscal Response

In the context of perfect foresight, intertemporal optimizing, and a 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 exchangerate policy is temporary leads to an initial expansion in consumption. 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, an ex-ante inconsistent stabilization program displays, ex-post, all the features of a fiscally consistent one such as a fixed exchange rate and no fiscal deficit. In contrast to the standard results, where the inconsistency between fiscal and exchange rate policy leads to a steady loss of international reserves and culminates in a Krugman type balance of payments crisis that forces the government to abandon the policy, this model predicts that along the path towards the Krugman type balance of payments crisis the economy displays no fiscal deficit and enjoys increasing international reserves