On fiscal discipline and the choice of exchange rate regime

The conventional wisdom in policy literatures has held that fixed rates induce more fiscal discipline than flexible rates. Empirical evidences doesn't support this view: fixed exchange rate regime is found to be significantly correlated with high budget deficits in Latin American countries and no correlation between high fiscal deficits and any regime is observed in industrial countries. The objective of my research is to investigate in great depth the relation between fiscal discipline and the choice of exchange rate regime.;Chapter 2 explores the question whether or not fixed rates would induce more fiscal discipline than flexible rates, and if so, under what conditions. The choice of exchange rate regime is exogenously given in this chapter. Using a standard intertemporal model with fragmented fiscal policy-making, I find: (1) future punishments in the form of currency depreciation against fiscal laxity exist under both fixed and flexible regimes. (2) fiscal authorities have a greater incentive to spend more today under fixed rates than under flexible rates, although they discount the future at the world real interest rate. (3) in the presence of both factors above, fixed rates will induce more fiscal discipline only if the punishment tomorrow is sufficiently stronger under fixed regime than under flexible regime.;The third chapter introduces endogenous choice of exchange rate regime, fixed versus flexible, in a bipartisan economy. The incumbent's regime choice lies in a trade-off between "tying the hands of future government" and "affecting electoral results". I show that the incentive to "tie the hands of its opponent" leads the Right (Left) incumbent to choose fixed (flexible) regime, whereas the incentive to increase its chance of re-election leads the Right (Left) incumbent to choose flexible (fixed) regime.;Chapter 4 analyzes the role of government's discount rate in determining the relation between fiscal discipline and the choice of exchange rate regime. I show that an impatient government tends to choose fixed regime because it allows the government to run large budget deficits without being punished immediately by high inflation. This proves the hypothesis proposed by Calvo (1987) and by Gavin and Perotti (1998).