Social pacts and macroeconomic adjustment: the relationship between fiscal adjustment and exchange rate movements, and what it means for EMU

Marzinotto, Benedicta (2009) Social pacts and macroeconomic adjustment: the relationship between fiscal adjustment and exchange rate movements, and what it means for EMU. In: UNSPECIFIED. (Submitted)

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Abstract

This paper provides a political economy explanation for the occurrence of fiscal consolidation by looking at the distributional effects of preceding real exchange rate depreciations across and within countries. Existing studies show that successful fiscal consolidation episodes tend to be preceded by downwards exchange rate movements (Giavazzi and Pagano 1990; Hjelm 2002; Lambertini and Tavares 2005). We show that the mechanism through which this happens differs across open and closed economies. In the former, there is a “good-times effect” following depreciation that induces the public to accept fiscal reform in the form of a social pact that contains budgetary provisions, provided it has similar distributional implications. By contrast, in closed economies, real depreciations impact differently on different socio-economic groups. That way, they open up room for a political exchange between competing interests that is likely to lead to a social pact and to fiscal reform, the wider its distributional implications. The argument is tested on a sample of OECD countries over 1987-2009.

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