The associated values Ф and t* are 0.49 and 2.91, respectively. Alternatively we could fix MT and seek the value of // that maximizes Ф. We did not pursue this experiment because it yields extreme results in our model: at the cost of hyperinflation the government could delay the attack for a very long (but finite) period of time. This is because the government can seize all private wealth by generating sufficiently high inflation. It’s ability to do so is an artifact of two assumptions which we make in our model: the cash in advance constraint applies only to consumption, and output is exogenous fully.

We conclude by noting that Figure 3 and the results of this section convey a common message: changes in the threshold rule, Ф, do not affect the inevitability of the speculative attack, only its timing and how much monetary policy must be adjusted to balance the government’s budget. A government can substantially delay the collapse of a fixed exchange rate regime by borrowing but only at the cost of higher future inflation. Because of this, it is not obvious that a government should borrow to delay an attack, even if it can. We now address the question of what monetary policy should the government pursue.

Optimal Monetary Policy

This section demonstrates that the optimal monetary policy in our economy is to abandon the fixed exchange rate regime as soon as new information about the deficit arrives. The required seignorage revenues should be raised by an increase in Mq and/or setting the growth rate of money to a constant, ц. This monetary policy succeeds in balancing the government’s intertemporal budget constraint without inducing distortions into the economy. This result follows from three features of our model: output is exogenous, the cash in advance constraint applies only to consumption, and seignorage is rebated to the households.

To demonstrate the optimality of the proposed policy, suppose that the government could finance the increase in the present value of the deficit using lump sum taxes. The equilibrium under this financing strategy cannot be improved upon: the fixed exchange rate could be maintained and inflation would continue to be zero. Note that since tax revenue are rebated lump sum to households, consumption will remain at its initial steady state level, c.

We now prove the optimality of our candidate monetary policy by showing that it supports the same allocation as that which obtains when the government raises to lump sum taxes. Recall that the optimal behavior of consumption is dictated by equation (2.6). It follows that if 7tt is constant, consumption will also be constant. Since seignorage revenues are rebated to the household, the intertemporal budget constraint is unaffected and consumption will still equal c.

The associated values Ф and t* are 0.49 and 2.91, respectively. Alternatively we could fix MT and seek the value of // that maximizes Ф. We did not pursue this experiment because it yields extreme results in our model: at the cost of hyperinflation the government could delay the attack for a very long (but finite) period of time. This is because the government can seize all private wealth by generating sufficiently high inflation. It’s ability to do so is an artifact of two assumptions which we make in our model: the cash in advance constraint applies only to consumption, and output is exogenous fully. We conclude by noting that Figure 3 and the results of this section convey a