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This paper is based on Chapter 2 of my PhD dissertation at UCLA. I am indebted to the members of my committee, Sebastian Edwards, Arnold Harberger and Axel Leijonhufvud for their valuable suggestions and comments. I also thank Charles Adams, Javier Hamann, Paulo Neuhaus and Peter Quirk for their helpful comments. Of course, I am solely responsible for all remaining errors.
See, for example, the studies by Flood and Garber (1984), Connolly and Taylor (1984), Garber (1985), Obstfeld (1984, 1986b), Dornbusch (1987), Wyplosz (1986), Blackburn (1988) and Willman (1987). Additionally, almost all the recent literature on portfolio models applied to developing countries analyzes the consequences of a collapse of the official exchange rate in the presence of a parallel currency market; see, for instance, Kiguel and Lizondo (1986) and Edwards (1988, 1989).
By definition, market-determined exchange rate regimes are not subject to such “surprises” in official rate-setting.
Following the study by Cagan (1956), the works of Sargent and Wallace (1981, 1987), Evans and Yarrow (1981), Liviatan (1983), Dornbusch and Fischer (1986), Bruno and Fischer (1987) and others have discussed the stability properties of the two stationary equilibria for the inflation rate in a closed economy. Kharas and Pinto (1986) extend this line of analysis to an open economy with a dual and implicitly floating exchange rate regime.
This is a simplifying assumption of all the currency substitution-type portfolio models that use the framework developed by Calvo and Rodriguez (1977). See, for example, Connolly and Taylor (1984), Kiguel and Lizondo (1986), Kharas and Pinto (1986), Khan and Lizondo (1987) and Edwards (1988, 1989).
The assumption that the central bank sterilizes the capital gains stemming from its exchange rate policy implies that the nominal money stock at any point in time will be given by:
Most of the studies on “passive” monetary policy have modelled the linkage between the fiscal deficit and the rate of money creation by means of the closed-economy counterpart of equation (6); see Auernheimer (1983), Evans and Yarrow (1981) and Bruno and Fischer (1987). However, the use of this type of constraint for the case of an open economy requires two qualifications: first, monetary policy is restricted to domestic credit policy, and second, as said in the text, it must be assumed that foreign and domestic borrowing are not available for the country in question. For an analysis of speculative attacks when the government is able to borrow, see Obstfeld (1986a) and Buiter (1987).
Adding more structure to the real sector of the model by specifying, for instance, the consumption and production functions for tradable and nontradable goods and the behavior of the real exchange rate can be done easily. However, leaving the model at this level of aggregation will suffice to highlight the problem under analysis.
It must be noted that, despite the fact that this assumption has been adopted consistently by almost all portfolio models since the early developments of the monetary approach (see Johnson (1972)), the empirical studies on seigniorage collection have not distinguished the different implications of alternative rules regarding the sterilization of capital gains (see, for instance, the figures presented in Fischer (1982)). Indeed, although the same equilibrium condition would be obtained if it were assumed that the central bank monetizes the changes in valuation of international reserves, the empirical computation of the inflation tax would be different under the two rules.
This result was first obtained by Cagan (1956) and has been analyzed in detail for the closed-economy case by the literature mentioned in footnote 1/, page 2.
This behavior of the central bank implies either that it maintains its previously announced rate of crawl or that it follows some sort of backward-looking adjustment rule in setting this rate.
This type of programs have been studied extensively, at theoretical and empirical levels, by the literature on the Southern Cone liberalization reforms of the 1970s. See, for instance, Calvo (1986a,b), Edwards and Cox-Edwards (1987), Kiguel and Liviatan (1987) and Rodriguez (1982).
Notice that the authorities will also be tempted to carry out these surprises in the one-equilibrium models used by the literature on speculative attacks. In spite of the assumption that the agents foresee perfectly the law of motion of domestic credit and international reserves consistent with a given rate of devaluation, the private sector in these models does not have enough information to anticipate the imposition of capital controls or a discrete devaluation different to the one required when the peg is abandoned. Thus, when these events take place before the collapse date the agents are unable to take advantage of the potential capital gains created by the authorities’ measure. On this see Obstfeld (1984), Wyplosz (1986) and Dornbusch (1987).