Edited by Thomas Oatley and W. Kindred Winecoff
Chapter 15: Fixed exchange rate regimes and financial markets as sources of macroeconomic discipline
It is often argued that financial markets are a major source of much-needed discipline that can counter the political forces that often generate excessive fiscal deficits and money and credit expansion. Likewise there is frequent advocacy of the adoption of fixed exchange rates, sometimes even including a return to a gold standard, as a method of imposing macroeconomic discipline. Other popular views, however, run in exactly the opposite direction. Much recent research has argued that pegged exchange rates when combined with high capital mobility are highly crisis prone. This is often called the 'unstable middle' or 'two corners' hypothesis. Likewise one often hears allegations that financial markets are inherently unstable and hence generate unnecessary crises. The purpose of this chapter is to evaluate such claims by analyzing the effects of international sources of macroeconomic discipline, specifically international capital markets and the exchange rate regime. We begin with a brief review of the arguments that time inconsistencies can create the need for institutional arrangements to limit the scope of domestic monetary and fiscal policies. We emphasize the need to distinguish between actual constraints on policymaking, which are relatively rare, and the effect of these discipline devices on policymakers' incentives to implement time consistent policies.
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