Fiscal Devaluations

Abstract

We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a dynamic New Keynesian open economy environment.We perform the analysis under alternative pricing assumptionsproducer or local currency pricing, along with nominal wage stickiness; under arbitrary degrees of asset market completeness and for general stochastic sequences of devaluations.There are two types of fiscal policies equivalent to an exchange rate devaluation-one, a uniform increase in import tariff and export subsidy, and two, a value-added tax increase and a uniform payroll tax reduction.When the devaluations are anticipated, these policies need to be supplemented with a consumption tax reduction and an income tax increase.These policies are revenue neutral.In certain cases equivalence requires, in addition, a partial default on foreign bond holders.We discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.

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