Journal Issue
Working Paper Summaries (WP/93/55 - WP/93/95)

Summary of WP/93/90: “On Credible Disinflation”

International Monetary Fund
Published Date:
January 1994
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The main “stylized facts” from the attempts to stop chronic inflation using reductions in the rate of the devaluation are a sustained appreciation of the domestic currency, current account deficits and increases in real activity at the beginning of the programs, followed by contractions. Most explanations of these facts have relied upon the existence of backward-looking price-setting behavior or of credibility problems. This paper shows that those stylized facts can be obtained as an equilibrium outcome in an economy with continuous market clearing, rational expectations, and no credibility problems.

The paper studies the effects of a gradual decline in the rate of devaluation rather than the more traditional, unexpected permanent reduction, in a two-sector economy subject to a cash-in-advance constraint. The gradual reduction in the rate of devaluation constitutes a progressive reduction in the monetary “wedge” generated by the transactions technology. This yields an increasing path of consumption, which in the case of the nontradable good, can be obtained only with a protracted real exchange rate appreciation. An initial increase in net foreign assets allows consumption of the tradable good to increase over time even when its production is falling; hence, a progressive trade deficit (or reductions in the surplus) follows.

The fact that intertemporal substitution in labor supply appears to be higher than that in consumption is exploited to generate a boom in economic activity at the onset of the program. The progressive reductions in inflation further increase labor effort, as the implicit bias toward leisure that inflation induces is removed from the system. The paper argues that when credibility is gained in the early stages of the program, as in the Mexican stabilization of 1988-92, a recession may not follow the initial boom. Casual evidence suggests that increases in labor supply, coupled with a flexible labor market, played a significant role in the Mexican success--in accordance with the predictions of the model.

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