Exchange rate-based stabilizations often result in an initial output expansion and real appreciation. One explanation is that, in the presence of inflation inertia, a reduction in the nominal interest rate causes the domestic real interest rate to fall, thereby increasing aggregate demand. Inflation inertia also causes a sustained real appreciation of the domestic currency. This paper re-examines this phenomenon in the context of an intertemporal optimizing model.
The paper’s central finding is that a credible, once-and-for-all reduction in the rate of devaluation gives rise to appreciation of the real exchange rate and an initial expansion in aggregate demand only if the intertemporal elasticity of substitution exceeds the static elasticity of substitution between traded and nontraded (home) goods. Otherwise, aggregate demand does not increase during the first stages of the program. Specifically, when the intertemporal elasticity of substitution is lower than the elasticity of substitution between traded and home goods, aggregate demand for home goods falls following a permanent reduction in the devaluation rate. The paper also confirms the findings of earlier, reduced-form models (under all parameter configurations) that real interest rates initially fall on impact, and the domestic currency appreciates in real terms during the first stages of the program.