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By Bjorn Rother

This booklet explores the function of political components within the incidence of foreign money crises, utilizing an eclectic technique that blends case reports, a rigorous theoretical dialogue, and econometric research.

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Based on this expectations mechanism, we can derive the loss associated with cheating through comparing the future losses associated with maintaining the fixed exchange rate and with discretionary policy making, respectively. 22) and an output level of E[ y] = −τ . 16. 24 yields the future period punishment P that a decision to break the exchange rate commitment in the current period would engender. It amounts to E[P] = E[Ldc ] − E[Lfc ] = 1 1 (τ + y˜ )2 . 26) 1 1 (τ + y˜ )2 . 27) β s−t s=t or ET−1 [PT ] = β 1−β In these expressions, β is a factor indicating the inter-temporal preference of the monetary authority.

While constitutionally anchored terms should not be less than four years under normal conditions, a shorter de facto term length could reflect the situation of a country with very weak political institutions suffering from frequent turnovers in government, including irregular ones. 4 A fiscal veto player A political actor with the clout to override the central bank’s decision of whether or not to defend a fixed exchange rate when times get tough is a veto player. In this section, I will show how a fiscal policy 52 The Determinants of Currency Crises maker could indirectly play such a role through using its power to set the level of taxation on firms’ output.

Clearly, this expression could only be consistent with a stable exchange rate when the central bank does not pay any attention to its output objective—αc would need to approach infinity. 7) yd = −τ − 1 + αc and a policy loss for the institution of Ldc = 1 1 + αc 2 αc τ + y˜ + α μ 1+α 2 . 7 show that this equilibrium would typically not be very attractive from society’s point of view. It entails a costly inflationary bias to monetary policy with no mean gain in output over the level that reflects prevailing tax distortions.

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