University of Maryland
Department of Economics
Prof. Carlos A. Végh
Note: All the papers below are available as PDF files. You need Adobe Acrobat Reader to view and print these files. It is available free of charge from adobe. If you would like a hard copy of any of these papers or experience difficulties downloading the files, please send an e-mail to vegh@econ.bsos.umd.edu.
Procyclical Fiscal Policy in Developing Countries: Truth or Fiction? (with Ethan Ilzetzki; January 2008).
Based
on a large empirical literature, the idea that, unlike in industrial countries,
fiscal policy in developing countries is procyclical has all but reached the
status of conventional wisdom, sparking a growing theoretical literature that
attempts to explain such a puzzle. Some authors, however, have suggested that
this conventional wisdom could be more fiction than truth since, by and large,
the current literature has ignored endogeneity problems and may have simply
misidentified a standard expansionary effect of fiscal policy. To settle this
issue of causality, we build a novel quarterly dataset for 49 countries
covering the period 1960-2006, and subject the data to a battery of econometric
tests: instrumental variables, simultaneous equations, and time-series
methods. We find overwhelming evidence
to support the idea that procyclical fiscal policy in developing countries is
in fact truth and not fiction. We also
find evidence that fiscal policy is expansionary -- a channel disregarded by
the existing literature -- lending empirical support to the notion that
"when it rains, it pours."
The Non-Monotonic Relation between Interest Rates and the Exchange Rate (with V. Hnatkovska and A. Lahiri; August 2007).
Central banks typically raise short-term interest rates to
defend against currency depreciations.
The empirical literature in this area, however, has been unable to
detect a clear systematic relationship between interest rates and exchange
rates. We use an optimizing model of a
small open economy to rationalize the mixed empirical findings. The model has three key margins. First, higher domestic interest rates raise
the deposit rate. This raises the
demand for deposits and hence raises the money base. Second, firms need bank
loans to finance the wage bill. Higher
domestic interest rates induce a negative output effect since the effective
wage cost rises. Lastly, higher
interest rates raise the government’s fiscal burden. This negative fiscal effect of higher interest rates raises the
expected inflation rate thereby reducing the demand for cash. These opposing effects make the relationship
between nominal interest rates (both policy-controlled and market-determined)
and exchange rates inherently non-monotonic.
We calibrate the model and show that it matches the business cycle
statistics of the Argentine economy. We
then conduct policy experiments involving the domestic interest rate and
demonstrate the central result of the paper: the relationship between interest
rates and exchange rates is non-monotonic.
Small increases in interest rates both appreciate the currency and
induce a fall in the rate of currency depreciation. However, more aggressive increases in the domestic interest rate
can both depreciate the currency as well as increase the rate of currency
depreciation. Our results provide an
explanation for the inability of non-structural empirical models to find a
systematic relationship between interest rates and exchange rates.
Segmented Asset Markets and Optimal Exchange Rate Regimes (with A. Lahiri and R. Singh), published in Journal of International Economics (2007). Issued as NBER Working Paper No. 13154 (June 2007).
Abstract: This paper revisits the issue of the optimal exchange rate regime in a flexible price environment. The key innovation is that we analyze this question in the context of environments where only a fraction of agents participate in asset market transactions (i.e., asset markets are segmented). Under this friction alternative exchange rate regimes have different implications for real allocations in the economy. In the context of this environment we show that flexible exchange rates are optimal under monetary shocks and fixed exchange rates are optimal under real shocks.
When Is It Optimal to
Abandon a Fixed Exchange rate? (with
Abstract: The influential Krugman-Flood-Garber (KFG) model of balance
of payment crises assumes that a fixed exchange rate is abandoned if and only
if international reserves reach a critical threshold value. From a positive
standpoint, the KFG rule is at odds with many episodes in which the central
bank has plenty of international reserves at the time of abandonment. We study
the optimal exit policy and show that, from a normative standpoint, the KFG
rule is suboptimal. We consider a model in which the fixed exchange rate regime
has become unsustainable due to an unexpected increase in government spending.
We show that, when there are no exit costs, it is optimal to abandon
immediately. When there are exit costs, the optimal abandonment time is a
decreasing function of the size of the fiscal shock. For large fiscal shocks
immediate abandonment is optimal. Our model is consistent with the evidence
that many countries exit fixed exchange rate regimes with plenty of
international reserves in the central bank's vault.
Optimal Exchange Rate Regimes: Turning Mundell-Fleming’s dictum on its head (with A. Lahiri and R. Singh, November 2006) (forthcoming in a conference volume in honor of Guillermo Calvo, edited by Carmen Reinhart, Carlos Vegh, and Andres Velasco, to be published by MIT Press). Issued as NBER Working Paper No. 12684 (November 2006).
A famous dictum in open economy macroeconomics -- which obtains in the
Mundell-Fleming world of sticky prices and perfect capital mobility -- holds
that the choice of the optimal exchange rate regime should depend on the type
of shock hitting the economy. If shocks are predominantly real, a flexible
exchange rate is optimal, whereas if shocks are mainly monetary, a fixed
exchange rate is optimal. There is no obvious reason, however, why this
paradigm should be the most appropriate one to think about this important
issue. Arguably, asset market frictions may be as pervasive as goods
market frictions (particularly in developing countries). In this light,
we show that in a model with flexible prices and asset market frictions, the
Mundell-Fleming dictum is turned on its head: flexible rates are optimal in the
presence of monetary shocks, whereas fixed rates are optimal in response to
real shocks. We thus conclude that the choice of an optimal exchange rate
regime should depend not only on the type of shock (real versus monetary) but
also on the type of friction (goods versus asset market).
Procyclical
Government Spending in Developing Countries: The Role of Capital Market
Imperfections (with Alvaro Riascos, 2003)
Abstract: Whereas in the G-7 countries government consumption is essentially acyclical, in developing countries it appears to be highly procyclical (i.e., government consumption rises in good times and falls in bad times). Several explanations have been advanced to explain this puzzle, including political factors and borrowing constraints. This paper shows, however, that such differences in the procyclicality of government consumption are entirely consistent with a standard neoclassical model of fiscal policy in which policymakers optimally choose both the level of government consumption and taxes. We show that, with complete markets, the correlation of government consumption and output is zero (as in G-7 countries). With only risk-free debt, however, this correlation is typically above 0.7, suggesting that the lack of a sufficiently rich menu of financial assets might be a major determinant of the way fiscal policy is carried out in developing countries. Hence, the degree of market incompleteness is enough to explain the above "puzzle" in a standard neoclassical fiscal model. Incomplete markets are socially costly as they induce substantial volatility in both private and public consumption, which would not be present otherwise.
Output Costs, Currency Crises, and Interest Rate Defense of a Peg (with A. Lahiri). NBER Working Paper No. 11791 (November 2005), published in Economic Journal (2007)
Abstract: Central banks typically raise short-term interest rates to defend currency pegs. Higher interest rates, however, often lead to a credit crunch and an output contraction. We model this trade-off in an optimizing, first generation model in which the crisis may be delayed but is ultimately inevitable. We show that higher interest rates may delay the crisis, but raising interest rates beyond a certain point may actually bring forward the crisis due to the large negative output effect. The optimal interest rate defense involves setting high interest rates (relative to the no defense case) both before and at the moment of the crisis. Furthermore, while the crisis could be delayed even further, it is not optimal to do so.
When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies (with G. Kaminsky and C. Reinhart). NBER Working Paper No. 10780 (September 2004). Published in NBER Macro Annual 2004 (edited by Mark Gertler and Ken Rogoff)
The Unholy Trinity of Financial Contagion (with G. Kaminsky and C. Reinhart), NBER Working Paper 10061 (November 2003). Published in Journal of Economic Perspectives.
Abstract: Over the last 20 years, some financial events, such as devaluations or defaults, have triggered an immediate adverse chain reaction in other countries -- which we call fast and furious contagion. Yet, on other occasions, similar events have failed to trigger any immediate international reaction. We argue that fast and furious contagion episodes are characterized by "the unholy trinity": (i) they follow a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor. In contrast, when similar events have elicited little international reaction, they were widely anticipated and took place at a time when capital flows had already subsided.
Modern
Hyper- and High Inflation (with S. Fischer and R. Sahay), NBER
Working Paper 8930 (May 2002). [Published in JEL, September 2002.]
Abstract: Since 1947,
hyperinflations (by Cagan’s definition) in market economies have been rare.
Much more common have been longer inflationary processes with inflation rates
above 100 percent per annum. Based on a sample of 133 countries, and using
the 100 percent threshold as the basis for a definition of very high
inflation episodes, this paper examines the main characteristics of such
inflations. Among other things, we find that (i) close to 20 percent of
countries have experienced inflation above 100 percent per annum; (ii)
higher inflation tends to be more unstable; (iii) in high inflation countries, the
relationship between the fiscal balance and seigniorage is strong both in the
short and long-run; (iv) inflation inertia decreases as average inflation
rises; (v) high inflation is associated with poor macroeconomic performance;
and (vi) stabilizations from high inflation that rely on the exchange rate as
the nominal anchor are expansionary.
Living with the Fear
of Floating: An Optimal Policy Perspective (with A. Lahiri), NBER Working Paper No. 8391 (July
2001)
Abstract: As documented in recent studies, developing countries
(classified by the IMF as floaters or managed floaters) are extremely reluctant
to allow for large nominal exchange rate fluctuations. This “fear of floating”
is reflected in the fact that, in spite of being subject to larger shocks,
developing countries exhibit lower exchange rate variability and higher reserve
variability than developed countries. Moreover, there is a positive correlation
between changes in the exchange rate and interest rates and a negative
correlation between both changes in reserves and the exchange rate and changes
in interest rates and reserves. We build a simple model that rationalizes these
key features as the outcome of an optimal policy response to monetary shocks.
The model incorporates three key frictions: an output cost of nominal
exchange rate fluctuations, an output cost of higher interest rates to defend
the currency, and a fixed cost of intervention.
Delaying the
Inevitable: Optimal Interest Rate Policy and BOP Crises (with A.
Lahiri), NBER Working Paper 7734 (June 2000).
[Published in JPE, April 2003, under the title “Delaying the
Inevitable: Interest Rate Defense and BOP Crises.”]
Abstract: The classical
model of balance of payments crises implicitly assumes that the central bank
sits passively as international reserves dwindle. In practice, however, central
banks typically defend pegs aggressively by raising short-term interest rates.
This paper analyzes the feasibility and optimality of raising interest rates to
delay a potential BOP crisis. Interest rate policy works through two distinct
channels. By raising demand for domestic, interest-bearing liquid assets,
higher interest rates tend to delay the crisis. Higher interest rates, however,
increase public debt service and imply higher future inflation, which tends to
bring forward the crisis. We show that, under certain conditions, it is
feasible to delay the crisis, but raising interest rates beyond a certain point
may actually hasten the crisis. A similar non-monotonic relationship emerges
between welfare and the increase in interest rates. It is thus optimal to
engage in some active interest rate defense but only up to a certain point. In fact,
there is a whole range of interest rate increases for which it is feasible to
delay the crisis but not optimal to do so.
Tax Base
Variability and Procyclical Fiscal Policy
(with
Abstract: Based on a sample of 56 countries, we find that while fiscal policy in the G-7 countries appears to be broadly consistent with Barro's tax smoothing proposition, in developing countries government spending and taxes are highly procyclical (i.e., government spending rises and taxes fall during expansions, while the reverse is true in recessions). To explain this puzzle, we develop an optimal fiscal policy model in which running budget surpluses is costly because they create pressures to increase public spending. Given this distortion, a government that faces large (and perfectly anticipated) fluctuations in the tax base will find it optimal to run a procyclical fiscal policy. We argue that the differences in fiscal policy between the G-7 countries and developing countries can be traced back to the fact that the tax base is much more volatile in developing countries than in the G-7 countries.
Inflation Stabilization and BOP Crises in Developing Countries (with G. Calvo), NBER Working Paper No. 6925 (February 1999). [Published in Handbook of Macroeconomics, Vol 1C (North-Holland, 1999), edited by J. Taylor and M. Woodford.]
Abstract: High and persistent inflation has been one of the distinguishing macroeconomic characteristics of many developing countries since the end of World War II. Countries afflicted by chronic inflation, however, have not taken their fate lightly and have engaged in repeated stabilization attempts. More often than not, stabilization plans have failed. The end of stabilizations ‑‑‑ particularly those which rely on a pegged exchange rate ‑‑‑ has often involve dramatic balance of payments crises. As stabilization plans come and go, a large literature has developed trying to document the main empirical regularities and understand the key issues involved. This paper undertakes a critical review and evaluation of the literature related to inflation stabilization policies and balance of payments crises in developing countries.
Banks and Macroeconomic Disturbances under Predetermined Exchange Rates (with S. Edwards), Journal of Monetary Economics, Vol. 40 (November 1997), pp. 239-278. Also issued as NBER Working Paper No. 5977 (March 1997).
Abstract: As the recent Mexican crisis vividly illustrates, Latin
American countries often go through boom-bust cycles caused by both domestic
policies and external shocks. Such cycles are typically magnified by weak
banking systems which intermediate large capital inflows. This paper develops a
simple optimizing model to analyze how the banking sector affects the
propagation of shocks. In particular, we show how the world business cycle and
shocks to the banking system affect output and employment through fluctuations
in bank credit. We also analyze the countercyclical use of reserve
requirements. Econometric evidence for
Targeting the Real Exchange Rate: Theory and Evidence (with G. Calvo and C. Reinhart), JDE, 1995.
Abstract: This paper presents a theoretical and empirical analysis of
policies aimed at setting a more depreciated level of the real exchange rate.
An intertemporal optimizing model suggests that, in the absence of changes in
fiscal policy, a more depreciated level of the real exchange rate can only be
attained temporarily. This can be achieved by means of higher inflation and/or
higher real interest rates, depending on the degree of capital mobility.
Evidence for
Nominal Interest Rates, Consumption Booms, and Lack of Credibility: A Quantitative Examination (with C. Reinhart), JDE, Vol. 46 (April 1995), pp. 357-378.
Abstract: Exchange rate-based stabilization programs in chronic-inflation countries have often been accompanied by an initial expansion of private consumption followed by a contraction. This consumption cycle has been attributed to lack of credibility, in the sense that the public views the reduction in the devaluation rate as temporary. This paper assesses the quantitative relevance of the “temporariness” hypothesis by comparing the predictions of a simple model to the actual figures for seven major programs. The paper concludes that nominal interest rates must fall substantially for the “temporariness” hypothesis to account for an important fraction of the observed consumption booms.
Real Effects of Exchange Rate-Based Stabilizations: An Analysis of Competing Theories (with Sergio Rebelo), NBER Working Paper No. 5197, July 1995. [Published in Ben S. Bernanke and Julio J. Rotemberg, NBER Macroeconomics Annual 1995, pp. 125-174.
Abstract: This paper uses a unified analytical framework to assess, both qualitatively and quantitatively, the relevance of the different hypotheses that have been proposed to explain the real effects of exchange rate-based stabilizations. The four major hypotheses analyzed are: (i) the supply-side effects associated with an inflation decline; (ii) the perception that the exchange rate peg is temporary; (iii) the fiscal adjustments that tend to accompany the peg; and (iv) the existence of nominal rigidities in wages or prices.
Exchange Rate-Based Stabilisation under Imperfect Credibility (with G. Calvo), in Open-Economy Macroeconomics, edited by Helmut Frisch and AndreasWorgotter (London: MacMillan Press, 1993), pp. 3-28.
Stopping High Inflation: An Analytical Overview, IMF Staff Papers, Vol. 39 (September 1992), pp. 626-695.
Revised: 2/18/2008