Fiscal discipline and exchange rate arrangements - Evidence from the Caribbean

This paper assesses the nature of fiscal discipline under alternative exchange rate regimes. First, it shows that fiscal agencies under a currency union with a fixed exchange rate can have a larger incentive to overspend or "free ride" than those under other exchange rate regimes, owing to the agencies' ability to spread the costs of overspending in inflation tax across both time, given the fixed exchange rate, and space, given the currency union. In contrast, such free-riding behavior does not arise under flexible regimes owing to the immediate inflationary impact of spending. Next, empirically, fiscal stances in countries with fixed pegs and currency union regimes demonstrate greater free-riding behavior than do countries with more flexible regimes in fifteen Caribbean countries from 1983 to 2004.