This paper examines the effect of expectations about future fiscal policy on the behavior of real interest rates in exchange-rate based stabilization programs. The analysis is based on an optimizing model with imperfect capital mobility. The effects of a once-and-for-all (or fully credible) reduction in the devaluation rate are first examined. The steady-state effects are shown to be an increase in the marginal value of wealth, real money balances, private wealth, consumption, a concomitant fall in the nominal interest rate, and no effect on the real stock of foreign bonds or the after-tax real interest rate. On impact, while the nominal interest rate falls unambiguously, the effect on the real after-tax interest rate is indeterminate and is shown to depend, in particular, on the degree of capital mobility. The distinction between instantaneous and gradual portfolio adjustments plays a key role in understanding the short- and long-run dynamics induced by policy shocks.
The analysis then considers a two-stage policy sequence in which policymakers implement an immediate, permanent, reduction in the devaluation rate as the first step in a disinflation program. They also announce their intention to increase the tax rate on income in the future. Private agents, however, do not entirely believe the announcement regarding the fiscal component of the program, and attribute a positive probability to the possibility that the authorities will not implement the pre-announced increase in income taxes. The behavior of real interest rates at the inception of the program is shown to depend on the degree of credibility in the policymakers’ announcements. When agents believe that the increase in taxes is unlikely to be implemented, and provided that the degree of capital mobility is sufficiently high, domestic real interest rates are likely to fall. By contrast, when private agents believe with a high degree of certainty that the increase in the income tax rate will be effectively implemented, real interest rates may rise on impact. Thus, the behavior of real interest rates at the inception of exchange-rate-based stabilization programs may not reflect expectations about the sustainability of the initial exchange rate adjustment itself, but rather the degree of confidence that private agents attach to the future implementation of the fiscal measures that may be announced in conjunction with the initial set of deflationary policies.