the fiscal theory and central banks’ solvency
The central bank’s balance sheet has been in economists’ attentions for a long time. Since the late 1990s, researchers have used the government and the central bank’s balance sheet to develop the fiscal theory of the price level explaining how the central bank chooses the price level (Leeper 1991; Sims 1994; Cochrane 1996; Loyo 1999; Cochrane 2005). Recently, this attention in the central bank’s balance sheet has been magnified in academic researches since the Quantitative Easing initiated by some countries after the financial crisis. Hall and Reis (2015) research on the possibility of central banks being insolvent after QE, especially on the Fed and the ECB. However, fewer researchers have focused on the small open economies with the central bank targeting the exchange rate.
The first part of this paper applies the fiscal theory of the price level (Leeper 1991) to the exchange rate. The fiscal theory of the price level shows that a fiscal authority and its central bank can pin down the price level through choosing the balance sheet given that the fiscal policy is non-Ricardian. Tons of researchers have engaged in debating how well this theory works and whether or not fiscal policy is Ricardian. However, researchers have less interest in applying this theory to the exchange rate. Loyo(1999) shows that the fiscal theory of the price level can determine the equilibrium trajectory of inflation in an open economy, but does not relate to the exchange rate. Dupor(1999) uses a two-country cash-in-advance model and proves that under Ricardian fiscal policy, interest rate peg does not pin down the price level in each single country. ...
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...thout fiscal support. Then, I argue that the central bank can remain solvency with fiscal support under particular rule of dividend, which the central bank pays its net income to the government and the government supports the central bank whenever net income is negative. Finally, I show that the government can follow the central bank in choosing nominal bonds if possible in maintaining solvency without change of fiscal policy, but it might only happen in extreme circumstances, such as the foreign country announced QE.
The paper structures as the following: Section II presents the two-country model and solves for the equilibrium exchange rate; Section III shows the credible method to peg exchange rate with non-Ricardian fiscal policy; Section IV discusses the solvency of the central bank from intertemporal solvency to rule solvency, and Section V concludes the paper.
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