Fiscal Discipline and Exchange Rate Systems

A new 'fiscal' theory of price determination has implications for exchange rate systems and common currency areas. We show that deeper monetary integration requires the discipline of a Ricardian regime; that is, the government must guarantee fiscal solvency for any sequence of prices or exchange rates. Particularly striking results are that a currency peg is not credible without the discipline of a Ricardian regime, and a common currency area is not viable if fiscal policy in two (or more) of the countries in the union is Non-Ricardian. Interestingly, constraints written into the Maastricht Treaty are sufficient for a Ricardian regime.