Fiscal dominance in semi-open economies with managed exchange rate regimes: A theoretical and empirical analysis

This dissertation analyzes theoretically and empirically the role of fiscal dominance as defined by Sargent and Wallace (1981) in the behavior of inflation, the real exchange rate, and the stock of net international reserves in developing countries with imperfect capital mobility and managed exchange rate regimes. We develop an open-economy AD-AS model that imposes the government intertemporal solvency constraint and incorporates the assumptions of a managed exchange rate regime with imperfect capital mobility. We test the empirical relevance of the fiscal dominance hypothesis for Colombia and Venezuela, estimating vector error-correction and unrestricted vector autoregression models with annual and quarterly data. Our hypothesis that under a managed exchange rate regime, fiscal dominance should imply a dynamic relationship between fiscal deficits and net domestic credit is not supported by the data. Using either the net domestic credit to trend output ratio or the logarithm of the monetary base to trend output ratio, we find for both countries that the fiscal dominance hypothesis receives, at best, weak support. Fiscal deficits and/or the rate of growth of the monetary base to trend output, however, have an important effect on the behavior of inflation, but not on the real exchange rate or the stock of net international reserves.