Floating or fixed exchange rates: The role of government size

This paper contributes to the resurging debate on the reform of the international monetary system by studying how the size of the public sector influences the choice of the exchange rate regime. In response to a meeting of the Bretton Woods Committee in 1993, Anna Schwartz (2000) argued that a large public sector impedes the viability of an exchange rate regime with a fixed rule for convertibility. Quantifying her line of reasoning from a welfare-based perspective leads to three main results: (1) Returning to a fixed exchange rate arrangement implies high welfare losses for countries with large public sectors; (2) The welfare loss is increasing in government size; (3) Increasing the share of public expenditures reduces output volatility, yet increasing the level of distortionary taxes enhances it