Canzoneri (1985) and Rogoff (1985) showed that imposing symmetric penalties on a central bank for deviations from an announced inflation target would reduce the Barro-Gordon inflation bias, but only at the expense of distorting the central bank's stabilization effort. More recently, Walsh (1995) and Persson and Tabellini (1993) showed that a simple linear penalty on all observed inflation would eliminate the inflation bias without distorting the stabilization effort. We view this result as a methodological criticism of the Barro-Gordon model, and not a statement about the ease with which the bias can be eliminated. Thus, we begin by modifying the Barro-Gordon model to reintroduce the trade- off between inflation credibility and stabilization, even when linear inflation penalties are imposed. We then discuss how either type of penalty might actually be imposed, and ask whether inflation targeting (supported by one or the other type of penalty) is likely to bring a better resolution to the credibility-stabilization trade-off than the ERM.

Mechanisms for Achieving Monetary Stability: Inflation Targeting versus the ERM

The main aim of this thesis is to investigate from both a theoretical and empirical point of view how debt management may affect the choice of the monetary and exchange rate regimes and ultimately influence the stability of financial systems. The thesis is organised as follows. In Chapter 1, we develop a simple theoretical model to analyse how the choice of the maturity and denomination of public debt instruments affects the choice of the optimal monetary target. We then compare debt management to alternative institutional mechanism designs and find that delegation of monetary policy to an independent central banker is a better solution to inflationary temptations than the issuance of foreign or indexed debt. Chapter 2 extends the analysis and shows that foreign currency debt may reduce the probability of a collapse of a fixed exchange rate regime. However, conditional on a currency crisis, countries with larger shares of foreign currency debt tend to experience sharper devaluations. Econometric results referring to the countries adhering to the Exchange Rate Mechanism of the European Monetary System from 1979 to 1995 confirm these theoretical findings. In the second part of the thesis we look at the sources of financial vulnerability in a sample of emerging and developing countries from 1970 to 1997. In Chapter 3, we test the role of debt and exchange rate fragility in determining episodes of banking crises, while Chapter 4 extends the analysis of the causal link between currency and banking crises to episodes of twin crises. The results indicate that along with the increasing liberalisation and globalisation of the financial markets, banking and currency crises have become closely intertwined and driven by common fundamentals. Finally, Chapter 5 contains a description of the econometric specifications and simulation-based estimation techniques adopted in the second part of the thesis.

Sources of financial fragility: The role of debt management.

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Sources of financial fragility: The role of debt management.