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

This compilation of summaries of Working Papers released during July-December 1993 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street N.W., Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201

Abstract

This compilation of summaries of Working Papers released during July-December 1993 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street N.W., Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201

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.

Working Paper Summaries (WP/93/55 - WP/93/95)
Author: International Monetary Fund