Do Monetary Handcuffs Restrain Leviathan? Fiscal Policy in Extreme Exchange Rate Regimes

This paper studies fiscal policy in countries that have chosen an extreme monetary stance. We think of a country as having an extreme monetary policy if it is in either a currency board or a common currency area. In much of our analysis, we distinguish between multilateral currency unions (such as the East Caribbean Currency Area, or ECCA) and countries that have unilaterally adopted the currency of an anchor country (such as Panama).

It is possible to motivate our analysis in several ways. A number of countries are considering whether to abandon national monetary sovereignty and unilaterally adopt the money of another country, including Mexico and Argentina; Ecuador, Guatemala, and El Salvador are already proceeding with dollarization. In Europe, 12 countries have already abandoned national monetary discretion within the Economic and Monetary Union (EMU). More generally, there has been much discussion of the “disappearing center” of exchange rate regimes; countries are said to have a choice of either freely floating or going to an extreme monetary stance.

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Revive Lincoln’s Monetary Policy – An Open Letter to President Obama

Dear President Obama:

The world was transfixed on that remarkable day in January when, to poetry, song, and dance, you gazed upon Abraham Lincoln’s likeness at the Lincoln Memorial and searched for wisdom to navigate these difficult times. Indeed, you have so many things in common with that venerable President that one might imagine you were his reincarnation in different dress. You are both thin and wiry, brilliant speakers, appearing on the national stage at pivotal times. Fertile imaginations could envision you coming back dressed in that African heritage you freed, to help heal the great scar of slavery and prove once and for all the proposition that all men are created equal and can achieve great things if given a fighting chance.

As Wordsworth said, however, our birth is but a sleep and a forgetting; and if that is true, you may have forgotten a more subtle form of slavery from which Lincoln tried less successfully to free his countrymen. You may have forgotten it because it has been omitted from our popular history books, leaving Americans ill-equipped to interpret the lessons of our own past. This letter is therefore meant to remind you.

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Has Monetary Policy Been So Bad That It Is Better to Get Rid of It? The Case of Mexico

MANY LATIN AMERICAN COUNTRIES are considering adopting the U.S. dollar as legal currency, and some, like Ecuador, have taken concrete steps in that direction. Proponents of dollarization generally hold the view that domestic monetary policy has been the primary cause for the economic instability experienced by these countries in the past three decades. Yet, at least for Mexico, very few empirical studies have tried to identify the role of monetary policy.

The existing empirical literature on Mexican monetary policy consists mainly of single equation estimations (see Calvo and Mendoza 1996 and Kamin and Rogers 1996), or of reduced-form vector autoregressions (see Copelman and Werner 1995 and Hernandez 1999).(1) The first class of models is silent on the impact of monetary policy on the rest of the economy. The second class of models, by definition, cannot identify monetary policy. In addition, all previous literature has either ignored the issue of changes in regime, or has confined itself to the study of monetary policy within regimes. This despite the fact that some of Mexico’s major crises occurred during the passage from one regime to another. A proper evaluation of the impact of monetary policy on the Mexican economy requires that these critical transition periods are considered.

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