In recent years, a large number of developing countries have undertaken inflation stabilization programs. In many instances, these programs have been accompanied by structural reforms in the external sector, in particular trade liberalization. It has been increasingly recognized that the degree of openness of an economy, and the efficiency gains brought about by trade liberalization, can influence the success of a program. Yet the analytical literature on inflation stabilization has largely ignored the potential role that can be played by greater openness--both structural and policy-induced--in supporting a stabilization effort. This paper examines the implications of structural reforms to increase openness in determining the likelihood that an inflation stabilization program will be successful.
The paper identifies conditions under which different policies with regard to openness are likely to improve the probability of success of a stabilization program. In several empirically realistic cases, policies that promote openness, including trade liberalization policies, have a positive effect on the ex ante probability that a program will succeed. An important conclusion is that in cases where the exchange rate elasticities of imports and exports are sufficiently large (that is, the Marshall-Lerner condition holds), a greater degree of openness increases the probability of success. This is because with greater openness, the extent to which persistence in inflation in nontraded goods results in real exchange rate appreciation is dampened, thereby mitigating the adverse effect of this persistence on the trade balance.
The paper derives additional conclusions about the likely effects of trade liberalization on the probability of success of stabilization by explicitly considering the role of trade taxes in budgetary revenues and the role of imported intermediate goods in the production process. The model suggests that trade reform would most strongly support a stabilization effort when the productivity of imported inputs is high and the price elasticity of imports is low.