Good Housekeeping? Reputation, Fixed Exchange Rates, and the 'Original Sin' Problem

Abstract

This paper examines how the choice of exchange rate regime can signal financial rectitude and, in so doing, influence a country's ability to borrow internationally in domestic currency. We develop a model in which the constant probability of a 'type change' creates incentives for disciplined policymakers to fix the exchange rate in an effort to separate themselves from more opportunistic types. Because the track record of a policymaker is imperfectly observable, reputational incentives depend on the past behaviour of previous generations and there is hysterisis in the updating behaviour of creditors. 'Original sin' - the inflationary track record of one's predecessors - can reverberate over time leading creditors to be wary about extending sovereign loans in domestic currency terms. Our findings seem consistent with the pattern of the currency composition of debt in Japan and Russia at the turn of the nineteenth century.