Debt sustainability and exchange stabilisation: Towards a new theory

Abstract

The sustainability of debt is a crucial issue in developing and transitional economies. In this paper, it shows that a bubble in the real exchange rate could result in a sudden collapse in the sustainability of a country's debt. Furthermore, it is shown that monetary authorities may be unable to control the exchange rate, as its dynamics also depends on that of the debt. Hence, the only feasible policy measure to stabilise the real exchange rate is to increase domestic non-price competitiveness to ensure an improvement in the trade balance of the economy.