Chapter

Inflation Stabilization and Nominal Anchors 4

Editor(s):
Richard Bart, and Chorng-Huey Wong
Published Date:
June 1994
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Since the late 1940s, many developing countries have suffered from chronic inflation. Chronic inflation is characterized by high—relative to industrial countries—and persistent inflation (Pazos (1972)). Unlike hyperinflation, which is measured in terms of months and exhibits an explosive nature, chronic inflation may last several decades and is relatively stable. By Harberger’s (1981) definition—annual inflation of 20 percent or more for at least five consecutive years—countries such as Argentina, Brazil, Chile, Israel, Mexico, Peru, and Uruguay have experienced long periods of chronic inflation.

Repeated attempts to eliminate chronic inflation have often met with only temporary success, after which inflation has returned with a vengeance. More often than not, the failure of stabilization plans reflects the absence of a lasting fiscal adjustment. Although Chile, Israel, Mexico, and, more recently, Argentina have all succeeded in reducing inflation to under 15 percent per year, even some fiscally sound programs (for instance, the Chilean and Uruguayan programs of the late 1970s) faced insurmountable hurdles.

The Southern Cone programs of the late 1970s in Argentina, Chile, and Uruguay were characterized by an initial boom that made reducing the inflation rate of nontraded goods particularly difficult. The recessionary effects that, according to conventional wisdom, should follow from inflation stabilization came only later in the program. The Southern Cone programs thus gave rise to the intriguing idea—captured by the expression “recession now versus recession later”—that the choice between using the money supply or the exchange rate as the nominal anchor may mean choosing the timing of the recession. With money-based stabilization, the output costs are paid up front (recession now), whereas with exchange rate-based stabilization, the costs are paid at a later stage (recession later).

The experience of the Southern Cone programs also led some observers to argue that a single nominal anchor might not be enough to ensure rapid disinflation, as lack of credibility, backward indexation, and nonsynchronized price setting tend to cause inflation to persist (see, for instance, Edwards and Edwards (1991)). These considerations prompted the introduction of additional nominal anchors—most notably incomes policies—in the programs of the mid-1980s in Argentina, Brazil, Israel, and Mexico.

This paper examines the role of nominal anchors in inflation stabilization programs in chronic-inflation countries. Section I reviews aspects of the experience of chronic-inflation countries undertaking inflation stabilization programs. Section II interprets the evidence in an analytical framework, and Section III analyzes the use of multiple anchors. Section IV presents policy conclusions.

I. Inflation Stabilization: Empirical Evidence

Reviewed here are the main empirical regularities associated with inflation stabilization in chronic-inflation countries.

Exchange rate-based stabilization

The following 11 major programs in Latin America and Israel are considered: (i) the heterodox programs of the 1960s in Argentina, Brazil, and Uruguay; (ii) the orthodox programs of the late 1970s (the tablitas) in Argentina, Chile, and Uruguay; (iii) the heterodox programs of the mid-1980s in Argentina, Brazil, Israel, and Mexico; and (iv) the 1991 Convertibility plan in Argentina (see, for instance, Kiguel and Liviatan (1992a) and Végh (1992)).

These programs share several characteristics.

Slow convergence of inflation to the rate of devaluation

The four-quarter inflation rate has remained above the four-quarter devaluation rate (Table 1).

Real appreciation of the domestic currency

Given the slow convergence of inflation, it should come as no surprise that the domestic currency has appreciated substantially in real terms (Table 1).

Table 1.Inflation, Devaluation, and Real Exchange Rate Appreciation in Selected Exchange Rate-Based Programs
Quarter Before

Program
Last Quarter

of Program
Real

Exchange

Rate

Appreci-

ation

(in percent)3
ProgramsPeriod1Devalu-

ation

Rate

(4Q

change)2
Inflation

Rate

(4Q

change)
Devalua-

tion

Rate

(4Q

change)
Inflation

Rate

(4Q

change)
Argentina 19671967.2-1970.185.626.60.08.525.0
Brazil 19641964.2-1968.2188.095.418.620.726.6
Uruguay 19681968.3-1971.3183.1167.20.023.628.6
Argentine tablita1979.1-1980.467.9167.323.188.746.3
Chilean tablita1978.1-1982.160.566.30.07.628.8
Uruguayan tablita41978.4-1982.328.341.915.125.248.2
Argentine Austral1985.3-1986.31,462.21,036.233.559.44.6
Brazilian Cruzado1986.2-1986.4211.0263.542.076.79.3
Israel 198551985,3-1990.2434.0386.13.316.416.7
Mexico 198751988.1-1992.4139.3148.41.413.236.6
Arg. Convertibility61991.2-1992.4106.8453.0-0.817.820.2
Sources: Bufman and Leiderman (1993), Di Telia (1983), Kiguel and Liviatan (1989), Machinea and Fanelli (1988), and IMF’s international Financial Statistics (various years).

Quarters during which the program was in effect. If a prograrn started late in a quarter, the following quarter is taken as the first quarter.

Four-quarter (4Q) change Indicates percentage change over same quarter of previous year.

Cumulative real appreciation (i.e., fall in the real exchange rate) during the program. Yearly data was used for Brazil 1964, Uruguay 1968, and Israel 1985.

Last quarter for devaluation and inflation refers to 82.1, before the devaluation rate was increased.

Duration of program has been arbitrarily set at five years.

Program in progress; terminal date determined by data availability.

Sources: Bufman and Leiderman (1993), Di Telia (1983), Kiguel and Liviatan (1989), Machinea and Fanelli (1988), and IMF’s international Financial Statistics (various years).

Quarters during which the program was in effect. If a prograrn started late in a quarter, the following quarter is taken as the first quarter.

Four-quarter (4Q) change Indicates percentage change over same quarter of previous year.

Cumulative real appreciation (i.e., fall in the real exchange rate) during the program. Yearly data was used for Brazil 1964, Uruguay 1968, and Israel 1985.

Last quarter for devaluation and inflation refers to 82.1, before the devaluation rate was increased.

Duration of program has been arbitrarily set at five years.

Program in progress; terminal date determined by data availability.

Deterioration of the trade balance and the current account

The current account normally worsened during the programs (Table 2). A similar pattern holds for the trade balance (Végh (1992)).1 Large trade account imbalances, fueled by imports of durable goods, were usually responsible for the current account deficits.

Table 2.Current Account and Real Interest Rates in Selected Stabilization Programs
Current Account Balance

(as percent of GDP)
Real Interest Rate2

(in percent per year)
ProgramsPeriod1Three

years

Before

Program
During

Program
Four

Quarters

Before

Program
First

Four

Quarters
Last

Four

Quarters
(average)
Exchange Rate-Based
Argentina 19671967-701.4-0.2
Brazil 19641964-68-1.20 0
Uruguay 19681969-711.7-1.7
Argentine tablita1979-812.1-2.50.7-2.85.9
Chilean tablita1978-82-3.1-8.670.943.046.4
Uruguayan tablita1979-82-2.8-4.618.2-7.224.9
Argentine Austral31986-2.8-3.620.048.0-7.5
Brazilian Cruzado31986-1.1-1.7-4.58.5-9.5
Israel 19854,51986-90-2.51.1-2.021.211.0
Mexico 198741988-920.7-3.9-2.929.22.0
Arg. Convertibility61991-92-0.6-2.638.1-2.04.0
Money-Based
Chile 197571975-77-3.1-3.1127.258.0
Argentine Bonex1990-3.61.7-7.4112.7
Brazilian Collor819903.22.0-8.1-2.4
Dominican Rep. 19906,91990-92-4.5-3.815.113.7
Peru 199061990-92-4.0-4.6-17.3235.048.1
Sources: Baliño (1991), Barkai (1990), Bufman and Leiderman (1993). Castro and Ronci (1991), Cukierman (1988), Kiguel and Liviatan (1989), Peréz-Campanero and Leone (1991), IMF’s international Financial Statistics (various years), and country authorities.

Calendar years during which the program was taken to be in effect for the purposes of current account figures.

Quarterly real lending rates unless otherwise indicated. Periods specified in Tables 1 and 4 apply. Ellipses indicate data are not available. Dashes indicate data do not apply.

Real interest rates are reported for two-quarter periods and exclude the initial price shock.

Duration of program has been arbitrarily set at five years.

Real interest rate before program refers to two quarters before.

Program in progress.

Annual real interest rates.

Monthly averages of overnight interest rates on government securities. Real interest rate after the program refers to first three quarters.

Real interest rates for 1991.3 and 1991.4. Before January 1991, interest rates were subject to controls.

Sources: Baliño (1991), Barkai (1990), Bufman and Leiderman (1993). Castro and Ronci (1991), Cukierman (1988), Kiguel and Liviatan (1989), Peréz-Campanero and Leone (1991), IMF’s international Financial Statistics (various years), and country authorities.

Calendar years during which the program was taken to be in effect for the purposes of current account figures.

Quarterly real lending rates unless otherwise indicated. Periods specified in Tables 1 and 4 apply. Ellipses indicate data are not available. Dashes indicate data do not apply.

Real interest rates are reported for two-quarter periods and exclude the initial price shock.

Duration of program has been arbitrarily set at five years.

Real interest rate before program refers to two quarters before.

Program in progress.

Annual real interest rates.

Monthly averages of overnight interest rates on government securities. Real interest rate after the program refers to first three quarters.

Real interest rates for 1991.3 and 1991.4. Before January 1991, interest rates were subject to controls.

Initial increase in real activity (i.e., real private consumption and real GDP) followed by a later contraction

Table 3 shows the growth of private consumption before and after stabilization; real GDP figures follow a similar pattern (Végh (1992)). In Israel, the late slowdown occurred in spite of the program’s success. The Mexican program proved to be an exception, in that no late recession occurred. The boom-recession cycle was usually more pronounced for durable goods consumption, as shown in Table 3 for Israel.

Table 3.Private Consumption in Selected Stabilization Programs(Annual rate of growth, in percent)
ProgramsPeriod1Three

Years

Before

Program

(average)
first

Year
Second

Year
Third

Year
Fourth

Year
Fifth

Year
Exchange Rate-Based
Argentina 19671967-706.82.64.06.44.14.4
Brazil 196421964-683.63.30.74.39.610.2
Uruguay 19681969-710.58.26.41.0-0.2
Argentine tablita1979-81-4.214.45.6-3.6-13.3
Chilean tablita1978-821.07.56.56.810.1-12.1
Uruguayan tablita1979-820.29.05.02.4-9.7-9.1
Argentine Austral19861.27.90.7
Brazilian Cruzado19862.86.4-0.9
Israel 19853 Total41986-900.614.89.04.30.05.3
Durables-6.249.713.25.8-12.817.1
Mexico 198731988-920.31.86.35.75.04.9
Arg. Convertibility5,61991-92-2.16 710.8
Money-Based
Chile 19751975-77-6.3-11.40.316.07.5
Argentine Bonex1990-1.2-1.86.7
Brazilian Collar1990-0.5-2.53.9
Dominican Rep. 19906,71990-92-0.3-12.97.5
Peru 19906,71990-921.5-15.310.8-1.1
Sources: Bufman and Leiderman (1993), Favaro and Bensión (1993), Kiguel and Liviatan (1989), Lustig (1992), Medeiros (1993), Viana (1990), IMF’s International Financial Statistics (various years). World Bank tables, Fundacion Mediterranea, country authorities, and IMF staff estimates.

Calendar years during which the program was taken to be in effect. Figures reported include data up to one year after the program ended. Ellipses indicate data are not available. Dashes indicate data do not apply.

Average before the program corresponds to two years before.

Duration of program has been arbitrarily set at five years.

Total (durables and nondurables) private consumption.

Figure for second year corresponds to total (private and public) consumption.

Program in progress.

Figures correspond to quarterly real GDP and refer to the four-quarter rate of growth in the quarter before the program, two quarters after the program, and then every four quarters.

Sources: Bufman and Leiderman (1993), Favaro and Bensión (1993), Kiguel and Liviatan (1989), Lustig (1992), Medeiros (1993), Viana (1990), IMF’s International Financial Statistics (various years). World Bank tables, Fundacion Mediterranea, country authorities, and IMF staff estimates.

Calendar years during which the program was taken to be in effect. Figures reported include data up to one year after the program ended. Ellipses indicate data are not available. Dashes indicate data do not apply.

Average before the program corresponds to two years before.

Duration of program has been arbitrarily set at five years.

Total (durables and nondurables) private consumption.

Figure for second year corresponds to total (private and public) consumption.

Program in progress.

Figures correspond to quarterly real GDP and refer to the four-quarter rate of growth in the quarter before the program, two quarters after the program, and then every four quarters.

Ambiguous response of domestic real interest rates

While ex post domestic real interest rates fell in the early stages of the tablitas and Argentina’s Convertibility plan (although in Chile they remained extremely high), they appear to have increased substantially in the early stages of the heterodox programs of the mid-1980s (Table 2).

Money-based stabilization

Five major programs will be considered: the 1975 Chilean plan; the 1989 Bonex plan in Argentina; and the 1990 programs in Brazil (the Collor plan), Peru, and the Dominican Republic (see Edwards and Edwards (1991), Kiguel and Liviatan (1992b), and Medeiros (1993)).2

Given the small number of money-based programs in chronic-inflation countries, the evolution of the macroeconomic variables presented here should be viewed only as suggestive.

Slow convergence of inflation to the rate of monetary growth

Inflation persisted in some money-based programs, although it seemed to converge more quickly than in exchange rate-based programs (Table 4).

Table 4.Inflation, Money Growth, and Real Exchange Rate Appreciation in Selected Money-Based Programs
Quarter BeforeLast Quarter
ProgramsPeriod1Money Growth

(4Q

change)2
Inflation

Rate

(4Q

change)
Money

Growth

(4Q

change)
Inflation

Rate

(4Q

change)
Real

Exchange

Rate

Appreci-

ation

(in

percent)3
Chile 19751975.2-1977.4234.6363.6113.066.341.8
Argentine Bonex1990.1-1990.44,096.24,144.81,070.51,629.151.2
Brazilian Collor41990.2-1990.46,791.56,232.42,382.71,476.69.7
Dominican Rep. 199051990.3-1992.440.240.816.96.29.0
Peru 199051990.3-1992.21,823.62,085.673.786.925.5
Sources: Corbo (1985), IMF’s International Financial Statistics (various years), Instituto Brasileiro de Economia, country authorities, and IMF staff estimates.

Quarters during which the program was in effect. If a program started late in a quarter, the following quarter is taken as the first quarter.

Four-quarter (4Q) change indicates percentage change over same quarter of previous year.

Cumulative real appreciation (i.e., fall in the real exchange rate) during the program,

Monthly data; program period is 90.03-90.12. Real appreciation was computed using parallel exchange rate.

Program in progress; terminal date determined by data availability.

Sources: Corbo (1985), IMF’s International Financial Statistics (various years), Instituto Brasileiro de Economia, country authorities, and IMF staff estimates.

Quarters during which the program was in effect. If a program started late in a quarter, the following quarter is taken as the first quarter.

Four-quarter (4Q) change indicates percentage change over same quarter of previous year.

Cumulative real appreciation (i.e., fall in the real exchange rate) during the program,

Monthly data; program period is 90.03-90.12. Real appreciation was computed using parallel exchange rate.

Program in progress; terminal date determined by data availability.

Real appreciation of the domestic currency

The real exchange rate appreciated in all five programs, often substantially (Table 4).

No clear-cut response in the trade balance and current account

The trade balance and current account showed an ambiguous response (Table 2). If anything, the external accounts showed a short-run improvement.

Initial contraction in economic activity

As Table 3 suggests, money-based stabilization appears to have caused a sharp (though short-lived) contraction in economic activity at the beginning of the programs.

Initial increase in domestic real interest rates

The liquidity “crunch” associated with a money-based stabilization resulted in sharp increases in real interest rates (Table 2).

II. A Basic Analytical Framework

Since the model has been formally developed elsewhere (Calvo and Végh (1990 and 1993)), the assumptions will be reviewed only briefly and the results explained intuitively. The economy is small and open, with perfect capital mobility. On the demand side, the public consumes traded and nontraded (or home) goods. Consumers must use money to purchase goods and so face a cash-in-advance constraint. As a result, the opportunity cost of holding money (i.e., the nominal interest rate) affects the cost of consumption (i.e., the effective price of consumption). A fall in the nominal interest rate reduces the effective price of consumption by lowering the opportunity cost of holding money.

On the supply side, the supply of traded goods is fixed and the supply of nontraded goods determined by demand. Firms that produce nontraded goods stagger prices, taking into account the expected path of aggregate demand and the aggregate price level. This nonsynchronization in price setting implies that while the aggregate price level is fixed at each point in time, the inflation rate is free to adjust instantaneously.

Exchange rate-based stabilization

Policymakers may announce a reduction in the rate of devaluation. If the announcement is fully credible—in the sense that the public believes the reduction in the devaluation rate will be permanent—inflation falls immediately to the new equilibrium value determined by the lower rate of devaluation. Furthermore, there are no real costs associated with eliminating inflation at one fell swoop. This exercise may be useful in interpreting the end of hyperinflations (Végh (1992)).

Given the history of failed stabilizations, however, policies in chronic-inflation countries are not likely to be fully credible. So the announcement may not be credible, in the sense that the public expects the higher rate of devaluation to resume at some point. The fall in the nominal interest rate (due to perfect capital mobility) is then viewed as temporary, reducing the cost of present relative to future consumption. The ensuing increase in aggregate demand leads to expanded output and a trade deficit. The overheated economy keeps inflation above the rate of devaluation, resulting in a sustained real appreciation. Over time, the real appreciation reduces excess aggregate demand for home goods, causing output to decline. Eventually, the economy falls into a recession.

The model is thus able to rationalize most of the empirical regularities described in Section I. (See Reinhart and Végh (1992) for a quantitative analysis.) Furthermore, the boom-recession cycle occurs whether or not the program is eventually abandoned. Hence, the model may also explain recessions occurring in successful programs, such as Israel’s. Domestic real interest rates fall in the model; the decline is consistent with the evidence on orthodox programs. The high real interest rates observed in the heterodox programs may be explained by the use of additional nominal anchors (see below).

Money-based stabilization

Alternately, policymakers may announce a reduction in the rate of growth of the money supply. (The results that follow require that real money demand be interest-rate elastic, something that is not essential to exchange rate-based stabilization.) If the announcement is credible (i.e., the lower rate of money growth is expected to be permanent), the long-run demand for real money balances increases. Inflation must then fall below the rate of monetary growth to generate higher real money balances over time. The initial drop in inflation reduces the nominal interest rate, increasing real money demand. Since the real money supply is given on impact (given that the price level is sticky), there is excess demand for real money balances. Money market equilibrium can be restored only by a recession that reduces the demand for real money balances.3 This recession is brought about by higher real interest rates (which reduce today’s demand for home goods relative to tomorrow’s) and a real exchange rate appreciation (which decreases the demand for nontraded relative to traded goods).

If the announcement is not credible, the picture remains qualitatively unchanged, because, with an exogenous money supply and sticky prices, the results are driven primarily by the fact that the real money supply cannot change at the time the plan is implemented. The only difference is that the current account, which remains in balance if the announcement is fully credible, goes into deficit as people anticipating the policy’s reversal consume more. Quantitatively, however, credibility plays a crucial role: the less credible the program, the smaller the initial fall in inflation. Lack of credibility also mitigates the initial recession, because the nominal interest rate does not fall by much—it is not “anchored” exogenously at a lower level as it is with exchange rate-based stabilization—so real money demand increases very little. A lack of credibility is not costly, in the sense that lower benefits go hand in hand with lower costs.

The model’s predictions for money-based stabilization are consistent with the facts discussed above: the initial drop in inflation is accompanied by a recession, real appreciation, and high real interest rates. When a policy is not credible, the model predicts a current account deficit, although the evidence on this is not clear-cut.

III. Multiple Anchors

This section discusses the use of monetary and credit constraints and incomes policies as additional nominal anchors.

Tight monetary and credit policy

Too much liquidity in the initial stages of an exchange rate-based program may prove dangerous, because it finances the initial consumption binge and contributes to an initial real exchange rate appreciation. Therefore, policymakers have frequently attempted to use additional anchors to put a lid on the forces unleashed by too much liquidity. The 1985 Israeli plan, for example, included an explicit target for bank credit, which was to be implemented by increased reserve requirements, a higher discount rate, and a tightening of existing controls on short-term capital flows (Barkai (1990)). The ensuing liquidity “crunch” provoked a sharp initial rise in real interest rates (Table 2), perhaps explaining the initial (albeit brief) downturn in economic activity that preceded the consumption boom. Analytically, Calvo and Végh (1993) show that using money as an additional nominal anchor results in high real interest rates, real exchange rate appreciation, and an initial recession.

Sterilized intervention is a popular method of insulating the domestic money stock from the expansionary effects of capital inflows at the beginning of a program. But even if it proves effective in temporarily controlling the money supply, sterilized intervention may impose a severe fiscal burden, as the government is forced to pay higher interest rates on the public debt than it receives on the world market for its reserves (see Calvo, Leiderman, and Reinhart (1993)).

Price and wage controls

Inflation inertia (defined as inflation of nontraded goods that remains above the growth rate of the nominal anchor) has characterized many programs. It may result from, among other factors, lack of credibility (as in the model discussed above) or widespread backward indexation (Pazos (1972)). Price and wage controls have usually been advocated in the belief that they help fight inflation inertia and that they may make a program more credible. However, removing the controls too soon may unleash the same problems with credibility and inflation inertia the controls were supposed to address in the first place. Removing them too late may result in highly distorted relative prices with ensuing real costs.

More importantly, however, the use of incomes policies does not seem to alter the outcome of exchange rate-based stabilization: both orthodox and heterodox plans share similar characteristics, as discussed in Section I. This finding suggests that price and wage controls cannot solve the underlying problems related to lack of credibility. Rather than resorting to price controls, the best hope is probably to switch from backward- to forward-looking indexation—that is, to adjust wages at the beginning of the program according to expected inflation.

IV. Policy Conclusions

The preceding analysis suggests several policy conclusions.

  • Although a recession seems unavoidable when a stabilization policy lacks credibility, the timing of the downturn appears to depend heavily on the choice of the nominal anchor.

  • A lack of credibility may be more disruptive when exchange rates are predetermined than when they are floating. With money-based stabilization, lower credibility reduces the benefits (i.e., inflation falls by less) but the real effects tend to vanish as well. With exchange rate-based stabilization, lower credibility also reduces the benefits (inflation may even increase) but the real disruptions are magnified. If the public is perceived as highly skeptical, a money-based strategy can be less risky. On the other hand, if credibility is high (because there is a new administration taking over, for example), the exchange rate should probably be favored as a nominal anchor, as it allows for a speedier adjustment of real money balances.

  • Attempting to pursue a disinflationary policy while maintaining a competitive real exchange rate is likely to be self-defeating. Both theory (see Section II) and evidence (see Section I) suggest that real appreciation is an unavoidable byproduct of lowering inflation. Moreover, the public’s perception that the authorities may be pursuing both objectives at the same time is bound to undermine credibility further. The experience of Israel and Mexico suggests that in exchange rate-based programs, adjustments in the nominal exchange rate (i.e., devaluations or changes in the rate of devaluation) aimed at correcting the real appreciation should be postponed, if possible, until the fundamentals are perceived to be well under control. Initial large devaluations aimed at making room for the inevitable real appreciation also proved helpful in the cases of Israel and Mexico.

  • It should be stressed that the dynamics of disinflationary policy discussed in this paper are unrelated to fiscal problems. This fact is particularly worrisome because it illustrates the stabilization programs’ vulnerability to the private sector’s beliefs about the economic or political sustainability of such programs. A serious fiscal adjustment may not be enough to ensure the success of a program if, for some reason, the public believes that the plan will eventually be abandoned. Policymakers must be able to convince the public that a policy will be sustained over time.

  • Currency substitution, a widespread phenomenon in chronic-inflation countries, appears to tilt the balance in favor of the exchange rate as the nominal anchor (Calvo and Végh (1992)). If the elasticity of substitution between foreign and domestic currency is very high—which is bound to be the case after many years of high inflation—then the system may be left without a nominal anchor under flexible exchange rates. Otherwise, floating rates do provide a nominal anchor to the system. Currency substitution may make the initial liquidity “crunch” and the ensuing recession more severe as the public attempts to switch from foreign to domestic currency. But other things being equal, currency substitution appears to render the exchange rate more attractive as the nominal anchor.

Comment

Hans M. Flickenschild

My talk will be organized around two points. First, I will respond to the positions taken by W. Max Corden and Guillermo Calvo. Then I will discuss two countries I have been involved with in recent years—Bolivia and Poland—from the point of view of the exchange rate regimes chosen under their stabilization and adjustment programs. My discussion of these country cases is less an attempt to give the a priori reasons for the choices the authorities made than it is an effort to justify these choices ex post facto in the light of Mr. Corden’s and Mr. Calvo’s remarks.

I. Exchange Rate Choices and Fiscal and Monetary Policy

After listening to the two speakers, I find that some of my concerns about their taking what at first may appear to be polar positions have been allayed. Although IMF staff work in country-specific situations—which are always gray zones, mixing elements of the two extremes—we nonetheless need the orientation that the theories in their simplification and extreme position give us.

Mr. Corden’s discussion of the real targets approach seems to reach the conclusion that this approach is the “right” one. Such a statement risks bringing up an old, contentious issue between the IMF and World Bank staffs. In the Bank, the time horizon is the medium or long term, while in the IMF, we realize that the medium or long term is made up of many short terms. The IMF usually deals with countries where a medium-term real exchange rate objective, although important for the general orientation of policies, is not the most immediate policy concern. We usually come into a situation of great instability and need to advise countries on how to reduce inflation rapidly. Mr. Corden acknowledges these situations when he mentions two types of countries that are potential candidates for nominal exchange rate targeting: countries that have had low inflation in the past, and high-inflation countries, which may need to resort to pegging the nominal rate in order to break entrenched expectations. I would add a third exception to this list to cover countries that suffer sustained exogenous shocks, such as a severe terms of trade shock. In this situation, the real rate needs to be changed and adjustments made based on the new rate. With a nominal anchor policy, it will be essential in such cases to explain clearly to the population why the nominal rate has been changed, so that no adverse expectations are created.

I could not agree more with the second point in Mr. Corden’s conclusions. Appropriate noninflationary monetary policy must accompany any exchange rate policy that is chosen. According to the orthodox view, an appropriately tight fiscal policy is also necessary—the two things are often equated. They become different instruments only when capital mobility is sufficiently high.

Mr. Corden also observes that because of the current high degree of capital mobility, exchange rate changes should be made quickly and, if possible, in small installments. I agree with this position and less with Mr. Calvo’s, which would postpone exchange rate adjustments until the economic fundamentals are right. With the size and speed of capital movements in today’s world, waiting is likely to be a luxury governments cannot afford, especially in chronic-inflation countries, such as those in the Southern Cone.

Mr. Calvo maintains that the choice of the nominal anchor is crucial to the timing of recessions, the occurrence of which he views as almost inevitable, and suggests that recessions come early with money-based programs. At first glance, Bolivia’s experience seems to confirm this idea, because the country’s GDP experienced its sixth consecutive annual decline after the stabilization program was initiated. But I think there are good explanations in this case (which we will examine more closely in a moment), including the fact that the shocks were largely external and not necessarily the result of the type of anchoring. On the other hand, Mr. Calvo maintains that recessions occur late in a program if the exchange rate is pegged. In Poland, the exchange rate was pegged, yet the economy entered a recession at the very start. Again, there may be special factors at play, which we will examine more closely later on.

I certainly agree with Mr. Calvo’s second point: that lack of credibility is more disruptive under a pegged exchange rate regime than under a monetary anchor. Lack of credibility was one of the reasons Bolivia adopted a more flexible exchange rate arrangement. I also agree with Mr. Calvo’s statement that implementing disinflationary policy while trying to maintain the real exchange rate is self-defeating. This point embodies my major objection to the real exchange rate rule. My opposition to real rate rules was hardened by my involvement with Peru in the first half of the 1980s, when the IMF staff and Peruvian authorities tried to preserve international competitiveness by adjusting the nominal exchange rate in an attempt to offset the inflation differential. As a result, absent any serious constraint on bank-financed fiscal deficits, inflation climbed every year until there was a change of government. There is little solace in the fact that, without IMF assistance, the new government made matters worse. Because of such experiences, I think IMF staff in general are very much inclined to prefer a nominal anchor in a program. On the other hand, not every program leads to real exchange rate appreciation. It is not the necessary byproduct of an anti-inflationary program, as I hope Bolivia’s experience will show (see Chart 1).

Chart 1.Bolivia: Effective Exchange Rate Indices, 1979-92 (1980=100)

Source: IMF staff estimates.

On Mr. Calvo’s fourth point, I agree that currency substitution is a very important factor in deciding which exchange rate regime to adopt. In Bolivia, currency substitution was not an issue, but it was in Poland, where it had reached large proportions. Measured at market-determined exchange rates, almost two thirds of the money supply was in foreign exchange. High volatility of the exchange rate, which Poland experienced before stabilization, results in large fluctuations in the perceived value of financial assets of economic agents. In the end, the authorities may lose control over monetary policy.

With regard to Mr. Calvo’s final point—that the dynamics of disinflationary policy are “unrelated to fiscal problems”—I would say this: fiscal adjustment alone may not be enough, but it is the crux of a successful stabilization program, and no recent program has succeeded without it. However, credibility—acceptance of a government’s policies and the belief that they will hold—is also very important to a program’s success, and I do not see how a government can achieve credibility in the presence of a large fiscal imbalance and rapidly rising public debt.

I would not claim that IMF staff went systematically through all these points with the authorities of Bolivia and Poland in choosing exchange rate systems. Nonetheless, as will become apparent, the choices actually made—a floating rate for Bolivia and a pegged one for Poland—were the correct ones. For each country, the exchange rate regime adopted was consistent with the basic criteria relevant to such a decision.

II. Bolivia and Poland

The Bolivian program was initiated in late August 1985 and received IMF support in the form of a stand-by arrangement in June 1986. The arrangement had been negotiated earlier, but there was some fiscal slippage. In addition, the country’s terms of trade deteriorated sharply in late 1985. For these reasons, the program had to be renegotiated. Some people believe that Bolivia had actually fixed its exchange rate, but this notion is far from true: the IMF staff was strongly encouraging the authorities to keep the rate flexible. In a formal sense, Bolivia had adopted a “Dutch auction” system, under which the Central Bank was auctioning foreign exchange (which it received from state enterprises) on a daily basis (Table 1). I say “formal” because in fact the Central Bank had an undisclosed minimum reservation price and was very much inclined, to the extent that it had foreign exchange, to increase the supply elastically when demand increased. Hence, the rate tended to be relatively stable over protracted periods of time. But when demand increased sharply on a sustained basis, then indeed there was upward flexibility under the adopted system. With the Dutch auction system, every successful bidder had to pay the price submitted in the bid. Over time, however, the bids converged almost completely, because the participants in the market learned by trial and error what the Central Bank’s reservation price was in a given period. That price was not changed frequently, so bidders clustered their bids closely, often keeping the maximum and minimum within a spread of 2 percentage points.

Table 1.The Choice of a Nominal Anchor: How Two Countries Managed
BoliviaPoland
Exchange rate regimeManaged float (Dutch auction)Nominal anchor (USI peg)
Situation
International reservesNone; arrearsSubstantial but negative foreign exchange position
Stabilization fundNoYes
Currency substitutionNoYes
Capital mobilityYesNo
CredibilityLowHigh
OtherHeavy terms of trade losses, exchange rate determination depoliticized as a result of floatTerms of trade losses
Supporting policies
Fiscal policyEnergy price increases, wage freeze, tax reformSubsidy and real wage cuts, end of income tax relief
Monetary policyLiberalized interest rates, credit ceilingIncreased refinance rate, credit ceilings
Structural policiesPrice liberalization, decentralization, privatizationTax-based incomes policy, liberalized prices, privatization
After one year19861990
ResultObjectiveResultObjective
Growth (percent)-30-12-5
Inflation (12-month rate, percent)668424994
Change in net international reserves (USI, millions)-110-514,442245

In Poland, the situation was quite different. The stabilization and adjustment program initiated at the beginning of 1990 was soon followed by IMF support in the form of a stand-by arrangement that had been negotiated with the Polish authorities in November-December 1989. Accordingly, there was ample opportunity to discuss the exchange rate system. Once a decision had been reached to peg to the U.S. dollar, fairly complex calculations were necessary to justify the level of the peg. Using different assumptions, the IMF staff and Polish authorities came up with a scatter of rates between 8,300 and 11,700 zlotys; the rate picked was 9,500 per dollar.

What were the initial situations in the two countries that justified adopting a floating rate with a monetary anchor in one and a fixed rate with endogenous money in the other?

Reserves

One criterion was the reserve situation at the beginning of the program. Bolivia had no usable liquid reserves when it launched its stabilization effort in the second half of 1985. Under a democratic government, the country had been in political and social turmoil for several years and had finally entered hyperinflation. The measured inflation rate during the 12-month period ending in August 1985 was 23,000 percent. Actually, inflation had been running at an annual rate of about 60,000 percent in the final months before stabilization. Reserves were depleted, and arrears were accumulating rapidly. The government had not paid banks or other creditors, and there were no lines of credit to draw on for intervention. In this type of situation, it is risky to peg the exchange rate, since it is possible to set the wrong rate.

The reserve situation in Poland was quite different. There were substantial foreign exchange reserves in the banking system—especially in the National Bank of Poland (NBP). However, one factor was of great concern to the Polish authorities: the large foreign exchange liabilities to residents. The Polish system permitted both households and enterprises to hold foreign currency deposits, and the net foreign exchange position—in contrast with the international reserve position—was substantially negative. The Polish authorities were concerned about this “overhang” of foreign exchange liabilities. They could intervene by drawing on their substantial reserve assets but in doing so would risk favoring residents who wanted to take capital out of the country.

Stabilization fund

The Bolivian Government had no access to foreign credit at the time it began its program. Its predecessor had spoiled its reputation with international creditors, and the situation had been unstable for so long that initially nobody was willing to believe the authorities would stay the course. Bolivia had made six stabilization attempts between 1982 and 1985, all of which ended in failure. Nobody was willing to put up a stabilization fund to support a pegged exchange rate. On the other hand, Poland received an outpouring of international support that reflected the historical importance of the country’s attempt to break away from communism. Western countries—notably the United States and Germany—rapidly put together a fund amounting to $1 billion in the few days between Christmas 1989 and the New Year.

Currency substitution

Bolivia, unlike many other Latin American countries, had no foreign currency deposits in its banking system at the start of the stabilization program. The economy had been “de-dollarized” by decree in 1982. There was, of course, de facto dollarization in the form of widespread holdings of currency notes (mattress money) among the population, but the measured dollarization was zero. In Poland, however, it was quite high: foreign currency deposits amounted to 63 percent of the total money supply, as valued at the exchange rates prevailing when the exchange markets were unified at the start of 1990.

Capital mobility

In a bold but realistic move, the Bolivians threw open their exchange system completely at the outset. There was no way to police the borders for current transactions—essentially, foreign trade—so trade and payments restrictions attendant on these transactions could not very well be enforced. And capital controls would have been very difficult—if not impossible—to enforce, considering the general incompetence and run-down condition of the public administration. Poland’s approach was more nuanced. It adopted what amounted to convertibility for most current account transactions for the enterprise sector and full convertibility for the household sector. As a result, some capital flows, especially those the large state enterprises could initiate, remained under control.

Credibility

In Bolivia, both internal and external credibility were at rock bottom. The new President, the leader of the 1952 revolution, had handed over the Government in 1956 with a high inflation rate that the IMF had been called in to stabilize. In his fourth presidency (as the head of a party called the Movement of the Revolutionary Left), he was not expected to follow a conservative path to domestic stabilization, and Bolivia had no external credit standing. Polish credibility, by contrast, was high. The Solidarity Movement had just scored a resounding victory by winning all the contested parliamentary seats in the elections. The Communists were out of power, but a perceived external threat still existed in the guise of the Soviet Union. The Polish electorate appeared both united and determined to “tough it out,” and the authorities had both internal and external credibility.

Other factors

Two other criteria militated for a flexible exchange rate in Bolivia. First, the country had experienced heavy terms of trade losses. In a stroke of bad luck, the international tin agreement collapsed in November 1985, less than three months after the stabilization effort was launched. The price of tin—one of Bolivia’s two main exports—fell by 50 percent. The price of natural gas—the other important export—began to slide in the wake of declining oil prices in late 1985 and early 1986. And there was a third exogenous shock in mid-1986—a drug interdiction operation by the United States. U.S. troops, which had been invited into the country, disrupted activities in the coca-growing areas. As a result, the price of coca leaf fell to one tenth of what it had been. It has been estimated that the combined effect of these shocks accounted for the entire drop in GDP observed in 1986. Poland was also facing terms of trade losses, especially in transactions with member countries of the Council for Mutual Economic Assistance (CMEA). The CMEA was still functioning at the time, but it was clear that Poland’s imports of oil and gas from the Soviet Union would become much more expensive and that its exports of manufactured goods to other CMEA members would have to be sold at much lower prices. However, the relative importance of the terms of trade loss was not as great in Poland as in Bolivia.

In Bolivia, domestic politics provided an additional reason for a flexible exchange rate system. Because past governments had been known to fall as a result of devaluations, ministers and presidents did not want to take responsibility for new devaluations. The auction system provided an excellent way to depoliticize the process of setting the exchange rate.

Supporting policies and results

The supporting macroeconomic and structural policies of both countries are described briefly in Table I. On the whole, these policies were not out of the ordinary, except that Poland had a well-publicized second nominal anchor constraining wages. In Poland, wage bill increases were indexed to a fraction—initially, a very small fraction—of cost of living increases. Bolivia imposed a wage freeze of nine months in the public sector, but this second anchor was never a center of attention.

Table I also shows the objectives and the results of the first year of the programs. Bolivia suffered a loss of reserves. Under the program, a portion of the resources provided by the IMF was supposed to be used for intervention, but Argentina fell behind on gas payments, and thus the reserve loss was higher than envisaged. In Poland, the increase in reserves exceeded all expectations, reflecting both an unexpected export boom and much lower imports (despite a sharp real appreciation of the exchange rate (see Chart 2)), as well as favorable, private capital movements.

Chart 2.Poland: Effective Exchange Rate Indices, 1980-92

(1980=100)

Source: IMF staff estimates.

Summary of Discussion

The discussion centered on the different functions of the exchange rate and the advantages and drawbacks of using the exchange rate as a nominal anchor. The distinction was made between real fundamental variables, which determine the equilibrium real exchange rate, and nominal macroeconomic variables, such as the exchange rate and nominal wages (among others), which affect the actual real rate. Measuring the real effective exchange rate is to a large extent an art that is partly a function of the weighting scheme adopted for different components of the current account. In particular, it was agreed that the guiding principle in devising a weighting scheme should be to measure movements in competitiveness as accurately as possible. While the equilibrium real effective exchange rate of a country undergoing rapid structural change is likely to shift as a result of the changes, it is nevertheless important to try to assess the impact of the changes. In measuring the real exchange rate, it is important to distinguish between a tariff imposed to influence long-term resource allocation (e.g., for the protection of domestic industry), and a tariff imposed as a measure to slow the loss of reserves, which should not affect the equilibrium real rate.

The economic impact of a devaluation on a country was discussed in terms of propensities to consume, the effect of expectations on investment, and the structure of the government budget. Devaluation was judged to have a significant effect even if export elasticities were low, as imports would be rationed by higher prices rather than by quantitative restrictions. The effect on prices would be determined by the supporting monetary policy, as a devaluation would generate only a one-time rise in prices. Further discussion on devaluation highlighted the government credibility factor and the impact of a devaluation on domestic absorption.

Regarding government credibility, the point was made that it was essential for the government to maintain its credibility after a devaluation; this could be done more easily if there was a history of government credibility or if a new government devalued soon after coming into power. If the public realized that there would be a devaluation whenever a real exchange rate misalignment occurred, the government would completely lose its credibility and ability to control inflation.

While a devaluation would normally cut real wages and consumption and absorption, the opposite effect on absorption could occur if profits were raised as a result of the devaluation, leading to expectations of increased future profits and, consequently, higher investment expenditures. In Mexico, for example, a devaluation combined with other policies contributed to an investment boom that benefited primarily export industries. In terms of the fiscal effects of a devaluation, evidence suggested that absorption depended on the particular country’s revenue structure and debt service profile.

It was made clear that a nominal exchange rate anchor was just one of several possible nominal anchors. While some participants favored an exchange rate anchor, others were afraid that it would erode competitiveness. It was agreed that if exchange rates were used to maintain competitiveness, the problem of inflation would remain unsolved unless another nominal variable was used to anchor prices. It was important that the nominal exchange rate anchor be viewed as credible, and in this context there was some support for a large one-step devaluation prior to the introduction of the fixed rate anchor, so that another devaluation would not be needed soon. There was considerable opinion, however, that most countries with an independent central bank should not commit themselves permanently to a fixed exchange rate. Exceptions would be desirable only for very small countries and countries with a long tradition with a fixed rate. Several cases were also mentioned in which a nominal exchange rate anchor was unlikely to be successful if the underlying fiscal imbalances were not first addressed.

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Note: This is a revised version of a paper presented at the Western Economic Association International 67th Annual Conference, San Francisco, July 9-13,1992, in a session organized by John Welch of the Federal Reserve Bank of Dallas. The authors are grateful to José Fajgenbaum, Carlos Medeiros, Gerald O’Driscoll Jr., Ratna Sahay, Pierre Siklos, Peter Wickham, conference participants, and two anonymous referees for helpful comments and discussions. A previous version of this paper was issued as an IMF working paper (PPAA 92/4). The views expressed in this paper are those of the authors and do not necessarily represent those of the International Monetary Fund.

The improvement in the current account in Israel is related mainly to the fall in investment and the rise in unilateral transfers (see Bufman and Leiderman (1993)). There was, however, a trade deficit during the five years following the program that averaged 7.1 percent of GDP.

In the Dominican Republic plan, dual exchange rates were in place for a year before being unified into a single floating rate (see Medeiros (1993)). Under dual rates, however, money is still the nominal anchor.

In theory, this initial recession could be avoided simply by engineering an initial once-and-for-all increase in the level of the nominal money supply at the same time that the rate of change of the money supply is being reduced. In practice, however, this is likely to be interpreted as a lack of commitment to a tight monetary policy that would severely undermine the credibility of the program.

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