Corruption Clubs: The Allocation of Public Expenditure and Economic Growth

Motivated by the experiences of Mexico and Argentina, we explore a model intended to capture the interactions among exchange rate policy, fiscal policy, and default on foreign currency-denominated debt. Our objective is to examine how exchange rate policy affects the supply of short-term debt facing the government. We show that under a conventional soft peg, it can be optimal for the government to choose a level of the exchange rate that may result in partial or complete debt default, as in the Mexican case. Paradoxically, default may also be an equilibrium outcome under a hard peg, as in the case of Argentina, precisely because devaluation is not an option. Multiple equilibria may exist under a soft peg, with one equilibrium featuring a high domestic interest rate, an overvalued exchange rate, a low level of output, and a high default probability. Under a hard peg, however, there is a unique equilibrium.