Since the government must collect seignorage revenues it must, at some point, abandon the fixed exchange regime.9

For simplicity we assume that the government will raise the seignorage revenues to balance its intertemporal budget constraint by a combination of a one time increase in the stock of money at time T equal to ДMT and growth in the money supply at rate ц from period T on. We denote the time period in which the government abandons the fixed exchange rate regime by t*. To determine t*, we must make assumptions regarding the government’s rule for abandoning the fixed exchange rate regime.

A Threshold Rule For Total Debt

In this section we consider a rule that is motivated by standard assumptions in the speculative attack literature. We assume that the government follows a threshold rule: it abandons the fixed exchange rate regime in the first period t* when bt — ft reaches Ф.

In the literature this threshold rule is typically specialized to apply only to the foreign exchange reserves of the government.10 This requires the additional assumption that the only component of the government’s portfolio that changes over time is the central bank’s foreign reserves. Then the threshold rule on total government debt is transformed into a threshold rule for reserves so that the government abandons the fixed exchange rate regime when reserves reach a certain lower bound.

Timing

To analyze how the economy reacts to the information about higher prospective deficits it is useful to distinguish between four intervals of time.

Time Interval 1: 0 < t < t*. This is the time interval after information about the higher future deficits has arrived but before the collapse of the fixed exchange rate regime. We denote the value of consumption, real balances and nominal money supply in this interval of time by c, in, and M, respectively.

Time Interval 2: t* < t < T. This is the time interval between the collapse of the fixed exchange rate regime and the new steady state flexible exchange rate equilibrium. We denote all variables that are time varying during this regime with a subscript t (e.g. ct is consumption). Variables which are constant during this time interval are denoted with a superscript *.

Time Interval 3: T T’. This is the time interval after which the new transfer policy is implemented. As with time interval 3, we represent all variables that are constant during this interval with a lower bar.

Since the government must collect seignorage revenues it must, at some point, abandon the fixed exchange regime.9 For simplicity we assume that the government will raise the seignorage revenues to balance its intertemporal budget constraint by a combination of a one time increase in the stock of money at time T equal to ДMT and growth in the money supply at rate ц from period T on. We denote the time period in which the government abandons the fixed exchange rate regime by t*. To determine t*, we must make assumptions regarding the government’s rule for abandoning the fixed exchange rate regime. A Threshold Rule For Total Debt In this section we consider a rule that is motivated by standard