This paper presents a model to study the dynamics of a currency crisis associated with a fiscal imbalance, defined as current or anticipated future decline in real primary surpluses. The model analyses the stock and maturity of nominal government liabilities as key determinants of the magnitude and predictability of the crisis. In our analysis, bond prices react to fiscal shocks, generating an unanticipated wealth transfer from the private to the public sector.
Provided the stock of long0term nominal liabilities is large enough, such transfer can guarantee, by itself, that the intertemporal government budget constraint holds with temporary price and exchange rate stability. Thus, a large stock of long0term nominal liabilities may help a government that, for any reason, does not want to let the currency depreciate immediately in the face of a destabilizing fiscal shock.
The implications of this point are best appreciated in relation to the analysis of Krugman (1979). In this classical model of currency crises, current and future fiscal deficits drive money creation above the rate that is consistent with a permanently fixed exchange rate, yet the central bank pursues a policy aimed at delaying the ultimately inevitable devaluation. An often overlooked feature of this policy experiment is that, when a speculative attack eventually precipitates a crisis, the loss of seigniorage associated with handing over reserves to speculators is endogenous and increasing in the anticipated money expansion.
Such loss of reserves may be equal to, or exceed, the revenue from seigniorage collected after the crisis. In this case, if the government wants to delay the devaluation, monetary financing of a fiscal imbalance is not even an option: in equilibrium, financing the imbalance via seigniorage and the goal of delaying the exchange rate adjustment are inconsistent with each other. Without long0term liabilities, and therefore without fiscal transfer associated with bond price movements, a fiscal shock would force the central bank to devalue immediately. With enough long0term liabilities outstanding, however, the government can temporarily postpone the abandonment of the peg even if net seigniorage revenue is zero.
While public sector solvency implies an upper bound on the latest possible date of an exchange rate adjustment, the timing of a crisis will also depend on the behavior followed by the central bank. In this paper, we propose a specification in which the central bank is willing to defend the peg as long as it can maintain the interest rate below some given threshold. The higher this threshold, the stronger is the central bank*s commitment to delay a collapse an upper bound on the interest rate indexes the tenacity with which the authorities defend the parity. We show that our cinterest rate rule implies, as a special case, the assumption of a lower bound on international reserves commonly adopted by the literature.
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