Exchange rates and currency crises
Fiscal discipline and exchange rate regimes: evidence from the Caribbean
Free-riding behaviour and looser fiscal discipline associated with restrictive exchange rate regimes within a Caribbean currency union
Authors:
R. Duttagupta; G. Tolosa
Publisher:
International Monetary Fund Working Papers, 2006
This paper studies the scope for moral hazards or ‘free-riding’ behaviour in fiscal policies under various exchange rate regimes. The purpose is to demonstrate that the exchange rate regime can also have a bearing on fiscal discipline.
Analysing the factors underlying fiscal efforts in15 Caribbean countries after controlling for institutional and other macroeconomic factors, the authors find that regimes with a fixed peg within a currency union (FPCU) are associated with exacerbated free-riding behaviour in fiscal policy, whereas flexible exchange regimes are not. The authors argue that under certain conditions, including the presence or expectation of fiscal dominance, a FPCU can allow member governments to transmit costs of fiscal overspending across time (to future governments) and space (to other countries within the union), and thus generate scope for greater fiscal indiscipline compared to other regimes. Conversely, the scope for such free riding does not arise under flexible regimes, given the immediate inflationary impact of overspending and the inability of fiscal agencies to share the costs with other countries.
Based on the empirical evidence from the Caribbean countries, the authors conclude that the consequence of choosing restrictive exchange rate regimes through FPCU backfired, and resulted in looser fiscal discipline than before, often causing costly adjustments. The authors therefore emphasise the importance of ensuring the consistency of fiscal policies with prevailing monetary arrangements. Under flexible regimes, the immediate inflationary consequence of fiscal overspending is one way to contain fiscal agencies’ urge for overspending. Under a currency union, members’ tendencies to free-ride on other member countries can be discouraged by clearly demonstrating the regional central bank’s unwillingness to yield to fiscal dominance and bail out members. Under fixed exchange rates, mechanisms to eliminate fiscal dominance would also eliminate the scope for intertemporal free riding.
