“Capital Inflows and Exchange Rate Policy” by Michael DEVEREUX
Authors:
Michael DEVEREUX
Hong Kong Institute for Monetary ResearchDavid Cook
The paper develops a model in which excessive capital inflows are associated with fixed exchange rates. The key components of the model are a) endogenous fiscal subsidies to international borrowing, b) an exchange rate rule followed by the central bank, and c) ex-ante wage setting with market power by wage setters. In this environment, a fiscal authority that lacks pre-commitment may distort international capital flows. But this depends critically upon the exchange rate rule. When the central bank follows a pegged exchange rate, then the fiscal authority will always subsidize capital inflows. The economy will engage in `over-borrowing', and in welfare terms may end up worse off than under capital market autarky. There is an optimal exchange rate rule however, whereby if the central bank allows the exchange rate to depreciate in response to an increase in domestic interest rates, it can sustain the full pre-commitment fiscal policy, without excessive capital inflows. Finally, we show that if fiscal policy must be financed by money creation rather than lump-sum taxes, then a fixed exchange rate rule may generate a joint exchange rate crisis and capital market crisis. In this fiscal-driven currency crisis, the exchange rate collapses at the same time that capital inflows are reversed.
