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This paper is taken from my Ph.D. dissertation. I am indebted to Luis Felipe Cespedes Cifuentes, Sanjay Kalra, Andres Velasco, Nancy Wagner, and participants at a seminar in the IMF’s Treasurer’s Department for suggestions and comments. The usual disclaimer applies.
We use “fixed rates” and “a fixed exchange rate regime”, “flexible rates” and “a flexible exchange rate regime” interchangeably in this paper.
Setting up a game of incomplete information with imperfect monitoring, Canavan and Tommasi (1997) argue that an exchange rate anchor provides more macroeconomic discipline because it is much easier for the public to monitor the nominal exchange rate than other variables. With the exchange rate anchor, the public could readily detect bad government behavior and threaten punishment. But Canavan and Tommasi did not directly address the impact on fiscal policy of different exchange rate regimes.
This is the reason why Tornell and Velasco could derive the same results no matter whether the fiscal authority makes transfers only in period 1 (1995) or in both periods (1998).
Technically speaking, the equilibrium of this paper is subgame perfect
Therefore, both the inflation rate and the nominal money growth rate lie between 0 and 1.
It does not make any difference whether the CB chooses fixed or flexible rates in the second period. The CB has to monetize the budget deficits in period 2 under either regime.