Fiscal discipline and the choice of a nominal anchor in stabilization

The conventional wisdom is that: exchange rate-based stabilizations induce more fiscal discipline than money-based programs. The Latin American experience does not support this view, Among the major stabilization programs implemented since 1960, the mean increase in the primary balance-to-GDP ratio was 3.2 percentage points under money-based programs, as opposed to only 0.2 percentage points under exchange rate-based programs. We present a model - where fiscal policy is set by an optimizing but non-benevolent government - that replicates this stylized fact. If the policy maker is impatient, a money-based stabilization provides more discipline, and higher welfare for the representative agent, than does an exchange rate-based stabilization. (C) 1998 Elsevier Science BN, All rights reserved.