Abstract
Fiscal Devaluations
Highlights
Exchange rate devaluations have long been proposed as a desirable policy response to macroeconomic shocks that impair a country’s competitiveness in the presence of price and wage rigidities
We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a dynamic New Keynesian open economy environment
First, despite the fact that the actual allocations induced by devaluations in New Keynesian environments are sensitive to the details of the environment, there exists a small set of fiscal instruments that can robustly replicate the effects—both on real variables and nominal prices—of nominal exchange rate devaluations across all specifications
Summary
Exchange rate devaluations have long been proposed as a desirable policy response to macroeconomic shocks that impair a country’s competitiveness in the presence of price and wage rigidities. Countries that wish to or have to maintain a fixed exchange rate cannot resort to exchange rate devaluations. In this paper we show how a country can use unilateral fiscal policy to generate the same real outcomes as those following a nominal exchange rate devaluation, while keeping the nominal exchange rate fixed. This question about fiscal devaluations dates back to the period of the gold standard when countries could not devalue their currencies. It has been conjectured that a similar outcome could be achieved by increasing value-added taxes and cutting payroll taxes (e.g., social security contributions)
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