Modern Money Theory (MMT) in the Tropics: Functional Finance in Developing Countries

In “Modern Money Theory (MMT) in the Tropics,” Matías Vernengo and Esteban Pérez Caldentey discuss the limitations of this approach for developing countries that have a sovereign currency, but borrow in foreign currencies. This creates a balance of payments constraint. They then analyze the limits of a country borrowing in its own currency, because the country can experience a currency devaluation, which then also creates balance of payments difficulties. They argue against flexible rates as a solution to this problem, in favor of managed exchange rates with capital controls.

Abstract

Functional finance is only one of the elements of Modern Money Theory (MMT). Chartal money, endogenous money and an Employer of Last Resort Program (ELR) or Job Guarantee (JG) are often the other elements. We are here interested fundamentally with the functional finance aspects which are central for any discussion of fiscal policy and have received more attention recently. We discuss both the limitations of functional finance for developing countries that have a sovereign currency, but are forced to borrow in foreign currency and that might face a balance of payments (BOP) constraint. We also analyze the limits of a country borrowing in its own currency, because there is no formal possibility of default when it can always print money or issue debt. We note that the balance of payments constraint might still be relevant and limit fiscal expansion. We note that flexible rates do not necessarily create more space for fiscal policy, and that should not be in general preferred to managed exchange rate regimes with capital controls. We suggest that MMT needs to be complemented with Structuralist ideas to provide a more coherent understanding of fiscal policy in developing countries.

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