Fiscal Imbalances and the Dynamics of Currency Crises

Abstract

This paper analyzes links between the fiscal theory of the price level (FTPL) and the first generation models after Krugman (Journal of Money Credit and Banking 11 (1979), 311–325), exploring the idea that a synthesis between the two can become a new framework to analyze the fiscal dimension of currency crises. Working in a simple synthetic framework, we show how external nominal shocks can cause a fiscal imbalance and undermine currency stability, resolve two well-known paradoxes of the first generation model, discuss the role of seigniorage revenues, and illustrate how fiscal and interest rate policies interact to determine the magnitude and the timing of speculative attacks and devaluations.