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Exchange Rate–Based Inflation Stabilization

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International Monetary Fund. Research Dept.
Published Date:
September 2001
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A. Javier Hamann

The last decade witnessed an intense debate on the benefits of using the exchange rate as a nominal anchor in disinflation. During the first half of the 1990s, several studies identified and tried to explain empirical regularities that occurred only under exchange rate–based stabilizations (ERBS). Subsequently, the notion of a distinctive ERBS cycle was challenged, mainly on the grounds that the initial findings could not be replicated in larger samples, and that the money-based stabilizations (MBS) used for comparison may not have constituted an adequate control group. New elements have also been brought into the debate, particularly the effects of the use of a particular anchor on the domestic financial system. The debate is far from over, as more sophisticated techniques continue to be used to disentangle the effects of ERBS from those generated by other types of stabilization and closer attention is paid to the issue of whether ERBS constitute inherently riskier strategies. This summary reviews IMF contributions to this debate.

In the early 1990s, Kiguel and Liviatan identified several empirical regularities that arise when inflation is brought down from chronically high levels using the exchange rate as the nominal anchor.1 The main features of this so-called ERBS “syndrome” include a boom-bust cycle in output, as opposed to the recessionary effects of MBS; a surge in consumption and investment; a pronounced real exchange rate appreciation; and worsening external accounts. Subsequently, a substantial amount of research—much of it carried out at the IMF—was devoted to further identifying the distinctive features of this syndrome and, later, to explaining it.2 Some attempts at identifying whether the syndrome was also observed in low-inflation countries yielded mostly negative results.3 On the other hand, empirical evidence from transition economies supported the existence of the ERBS syndrome.4

More recently, the notion of an ERBS syndrome has been challenged. Santaella and Vela (1996) observe that the studies identifying the ERBS syndrome are based mostly on casual observation across episodes and that their robustness has not been assessed properly.5 They argue that the Mexican experience in 1987–94 is not fully consistent with the ERBS syndrome. In work done at the World Bank, Easterly (1996) finds that disinflations from chronically high levels are accompanied by an acceleration in output growth, irrespective of whether the exchange rate is the anchor.6 Importantly, his sample—selected on the basis of the actual behavior of inflation—includes several African stabilizations, unlike the studies that first identified the syndrome, which relied on a small set of well-documented stabilizations in Latin America and Israel. Following a methodology similar to Easterly’s for identifying stabilizations, Hamann (1999) re-examines the ERBS syndrome and finds little support for it.7 Like Easterly, he finds no difference in the behavior of output during disinflation between ERBS and other stabilizations, although he does find evidence of a consumption boom during ERBS. In contrast, Fischer, Sahay, and Végh (2000) do find evidence that ERBS are characterized by higher output growth and a distinctive consumption/investment cycle.8 Although they, too, use a sample selected on the basis of the behavior of actual inflation, they focus on cases where prestabilization inflation was at least 100 percent a year, compared with 40 percent in the studies by Easterly and Hamann.

Case studies conducted recently at the IMF highlight two issues that help reconcile the conflicting findings described above: (1) the role of the anchor during disinflation is not as clear-cut as portrayed in theoretical comparisons of ERBS with MBS; and (2) for output dynamics, what matters is the de facto exchange rate regime rather than the announced regime (although, admittedly, the announcement of a path for the exchange rate—especially if not fully credible—may be a key ingredient in the theoretical explanation of the other elements of the ERBS syndrome). As explained by Fischer (1986), under MBS, the increase in money demand associated with lower inflationary expectations is associated with a recession needed to generate a decline in (sticky) domestic prices and, thus, an equilibrating increase in the real stock of money.9 Under an ERBS, the increased money demand is met by a larger nominal stock of money, achieved through a surplus in the balance of payments. No recession is needed, and the preannouncement of the peg is immaterial.

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Ross (1998); Wang (1999); and Horváth, Thacker, and Ha (1998) study the disinflation experiences of Slovenia, Georgia, and Armenia, respectively, in the 1990s.10 While these experiences differ in many respects, none relied on the preannouncement of an exchange rate path, and all entailed a rapid decline in inflation accompanied by a marked improvement in growth. Nonetheless, in all cases there was systematic intervention in the foreign exchange market and a gradual move to de facto pegs (to the deutsche mark in Slovenia and to the U.S. dollar in Georgia and Armenia). Given the fragmentation of the foreign exchange market and the prevalence of current account restrictions, it is unlikely that a preannounced exchange rate would have been an effective nominal anchor initially in these countries. Yet, the favorable evolution of output during disinflation in these cases may be related to the fact that systematic intervention in the foreign exchange market facilitated a quick remonetiza-tion.11 In a forthcoming article, Hamann, Arias, and Zhang (2001) look at the extent to which monetary dynamics in non–ERBS have been affected by intervention. Preliminary findings suggest that, in several instances, the behavior of domestic credit and foreign exchange reserves in non–ERBS cannot be distinguished from that of ERBS, raising the question of whether the early literature may have mislabeled some of the non-ERBS as MBS.12

The relationship between the financial sector and the use of an exchange rate anchor during disinflation—particularly when the ERBS takes the form of a hard peg—is the subject of two recent studies at the IMF. Gulde (1999) explains Bulgaria’s disinflation in 1997 with the adoption of a currency board whose rules had to be adapted to that country’s prestabilization banking prob-lems.13 Sobolev (2000) develops a theoretical model where banks do not internalize the effects of their lending operations on the quality of information faced by other banks.14 As a result, the rapid remonetization through capital inflows that characterizes ERBS leads to excessive lending and systemic financial fragilities, which make the economy vulnerable to banking and balance of payments crises.

Research at the IMF in recent years has, in many ways, tested the robustness of the ERBS syndrome identified in the early studies, with varying results. Moreover, theoretical work linking the use of an exchange rate anchor with the behavior of the domestic financial sector has opened up a promising direction for future research, that could shed some light on the key issue of whether ERBS constitute an inherently riskier strategy in countries integrated with international capital markets.

Miguel Kiguel and Nissan Liviatan, “The Business Cycle Associated with Exchange Rate-Based Stabilization,” The World Bank Economic Review (May 1992).

On the identification of the ERBS syndrome, see, for example, Carlos Végh, “Stopping High Inflation,” IMF Staff Papers (September 1992); Guillermo Calvo and Carlos Végh, “Inflation Stabilization and Nominal Anchors,” Contemporary Economic Policy (April 1994); and, Carmen Reinhart and Carlos Végh, “Inflation Stabilization in Chronic Inflation Countries: The Empirical Evidence” (unpublished; Washington: IMF, July 1994). Alexander Hoffmaister and Carlos Végh, “Disinflation and the Recession-Now-Versus-Recession-Later Hypothesis: Evidence from Uruguay,” IMF Staff Papers (June 1996), provides econometric evidence of the distinctive behavior of output in ERBS. IMF research aimed at explaining the syndrome includes Jorge Roldós, “Supply-Side Effects of Disinflation Programs,” IMF Staff Papers (March 1995); Carmen Reinhart and Carlos Végh, “Nominal Interest Rates, Consumption Booms and Lack of Credibility: A Quantitative Examination,” Journal of Development Economics (April 1995); Sergio Rebelo and Carlos Vegh, “Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories,” in NBER Macroeconomics Annual 1995 (Cambridge, Massachusetts: MIT Press); and May Khamis, “Credit and Exchange Rate Based Stabilization,” IMF Working Paper 96/51, 1996. A paper by R. Armando Morales, “Exchange Rate Uncertainty in Money-Based Stabilization Programs,” IMF Working Paper 98/3, 1998, shows that uncertainty about the behavior of the nominal exchange rate in MBS introduces a bias towards real appreciation in these programs.

IMF research in this area includes Enrica Detragiache and A. Javier Hamann, “Exchange Rate–Based Disinflation in Western Europe: Greece, Ireland, Italy and Portugal,” IMF Working Paper 97/75, 1997; later published in Contemporary Economic Policy (July 1999).

Stanley Fischer, Ratna Sahay, and Carlos Vegh, “Stabilization and Growth in Transition Economies: The Early Experience,” IMF Working Paper 96/31, 1996; later published in Journal of Economic Perspectives (Spring 1996).

Julio Santaella and Abraham Vela, “The 1987 Mexican Disinflation Program: An Exchange Rate–Based Stabilization?” IMF Working Paper 96/24, 1996.

William Easterly, “When is Stabilization Expansionary? Evidence from High Inflation,” Economic Policy (April 1996).

A. Javier Hamann, “Exchange Rate–Based Stabilization: A Critical Look at the Stylized Facts,” IMF Working Paper 99/132, 1999; forthcoming in IMF Staff Papers.

Stanley Fischer, Ratna Sahay, and Carlos Végh, “Modern Hyper- and High Inflations” (unpublished; Washington: IMF, January 2000).

Stanley Fischer, “Exchange Rate Versus Money Targets in Disinflation,” in Indexing, Inflation, and Economic Policy, ed. by Stanley Fischer (Cambridge, Massachusetts: MIT Press, 1986).

Kevin Ross, “Post Stabilization Dynamics in Slovenia,” IMF Working Paper 98/27, 1998; Jian-Ye Wang, “The Georgian Hyperinflation and Stabilization,” IMF Working Paper 99/65, 1999; Balasz Horvath, Nita Thacker, and Jiming Ha, “Achieving Stabilization in Armenia,” IMF Working Paper 98/38, 1998

Of course, output dynamics in the former Soviet Republics must also take account of the collapse in output that took place in the aftermath of the disruption of their trade regime and the terms of trade shock associated with the liberalization of energy prices.

A. Javier Hamann, Felipe Arias, and Lei Zhang, “Monetary and Exchange Rate Dynamics During Disinflation: An Empirical Analysis,” forthcoming IMF Working Paper, 2001.

Anne-Marie Gulde, “The Role of the Currency Board in Bulgaria’s Stabilization,” IMF Policy Discussion Paper 99/3, 1999; a shorter version was published in Finance and Development, Vol. 36 (September 1999).

Yuri Sobolev, “Exchange Rate–Based Stabilization: A Model of Financial Fragility,” IMF Working Paper 00/122, 2000.

IMF Research Bulletin

Coming in the December 2001 issue

  • Capital Controls

  • Currency Unions

  • Country Study: United States

  • Special Topic: Environmental Research

Visiting Scholars at the IMF, April–June 2001

Olumuyiwa Alaba; University of Ibadan, Nigeria

Lakshman Alles; Curtin University of Technology, Australia

Mike Artis; European University Institute, Italy

Philippe Bacchetta; Study Center Gerzensee, Switzerland

Sujit Chakravorti; Federal Reserve Bank of Chicago

Lawrence Christiano; Northwestern University

Daniel Cohen; Universite de Paris, France

Philip Corbae; University of Pittsburgh

Nick Crafts; London School of Economics, U.K.

Allan Drazen; University of Maryland

Mardi Dungey; Australian National University, Australia

Morris Goldstein; Institute for International Economics

Barry W. Ickes; University of California, Berkeley

Douglas Irwin; Dartmouth College

Talan Iscan; Dalhousie University, Canada

Michael Klein; Tufts University

Renu Kohli; Indian Council for Research on International Economic Relations, India

Randall Kroszner; University of Chicago

Ross Levine; University of Minnesota

Ronald MacDonald; University of Strathclyde, U.K.

Nancy Marion; Dartmouth College

Sugata Marjit; Centre for Studies in Social Sciences, Calcutta, India

George Mbangah; University of Yaounde II, Cameroon

John McDermott; Reserve Bank of New Zealand

John Mutenyo; Makerere University Institute of Economics, Uganda

Emmanuel Ogunkola; National University of Lesotho, Lesotho

Lee Redding; University of Glasgow, U.K.

Francisco Ruge-Murcia; University of Montreal, Canada

Luigi Ruggerone; Banca Commerciale Italiana, Italy

Fondoh Sikod; University of Yaounde II, Cameroon

Neil Wallace; Pennsylvania State University

Yunjong Wang; Korea Institute for International Economic Policy, Korea

Thomas Willett; Claremont Graduate University

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