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Domestic debt and credibility In addition, the existence of domestic-currency denominated public debt can generate BOP difficulties if the exchange rate policy is not fully credible. Suppose the government announces a fixed exchange rate but the public believes that the currency will be devalued next period by e times 100 with probability p. Then, if investors are risk neutral (in terms of foreign currency) the nominal interest rate satisfies:
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with the fiscal deficit now being positive since it > r due to the peso problem. Hence, the peso problem may put into motion Krugman’s BOP-crisis machinery.92 Thus, lack of credibility may result in an unsustainable balance of payments even though “fundamentals” could be fully in line with a sustainable situation. other

Credibility, the demand for money and fiscal deficits Credibility problems may be reflected through other more subtle, but equally important phenomena. As argued in Section 3, there is typically a consumption boom in the early stages of an exchange rate-based stabilization. Therefore, the demand for money will contain a cyclical component associated with the stabilization program. Higher monetization at the start of the program may give the impression to policymakers that the program enjoys a high degree of credibility.

An argument one commonly hears from policymakers is that higher monetization reflects the return of flight capital due to the higher confidence inspired by the stabilization plan. While this is partially true, policymakers may wrongly conclude that the higher stock of real monetary balances is a permanent positive shock. However, if monetization is provoked by the expectation that the program will be abandoned in the non-too-distant future, then the real stock of money will eventually collapse, possibly generating a BOP crisis.

In a recent study, Talvi (1996) shows that if tax revenue is an increasing function of consumption, then prior to crisis the fiscal deficit could shrink, giving the false impression that the fiscal house is in order. In an example, Talvi (1996) shows that the fiscal deficit is nil before the crisis, only to explode afterwards. This pattern of the fiscal deficit is understandably quite confusing to the average policymaker.

It is not unusual for the initial slackening of the fiscal constraint to be read as an indication that tax evasion has fallen and, hence, that the higher fiscal revenue has a significant permanent component. As a result, considerable political pressure is built up for more government spending. Unfortunately, if imperfect credibility is the key reason for the initial consumption boom and policymakers give in to pressures to increase government expenditure, then after-crisis fiscal deficits could reach dangerously high levels – which will become apparent only after a crisis erupts and policymakers have little room to manoeuver.

Concluding remarks

We have concluded our long journey through the fascinating world of inflation stabilization and balance of payment crises in developing countries. After examining the possible rationale behind the existence of chronic inflation in many developing countries, we carried out some simple econometric exercises which support the existence of two main puzzles in the area of inflation stabilization. First, exchange rate-based stabilization leads to an initial boom in real GDP, private consumption, and durable goods consumption.