1. From temporary loss to permanent gain

When prices are set free, the general price level begins to rise towards point H in Chart 2. This general price increase is accompanied by a change in relative prices because prices tend to increase most rapidly in those sectors where the initial excess demand was largest. At first, output contracts and unemployment emerges as inefficient firms go bankrupt in those parts of the economy where relative prices have fallen. The resulting contraction of aggregate supply from AS to AS’ increases the pressure on the price level so that it rises farther towards point J in the chart. ^3/ The slump in aggregate demand along the AD schedule may reduce output and employment temporarily also in those markets where relative prices have risen, due to the spillover effects of bankruptcies across sectors. With or without such chain reactions triggered by ‘Keynesian’ demand deficiency, this process continues until new profit opportunities and incentives arising in markets where relative prices have increased begin to be exploited by resourceful entrepreneurs. When this occurs, productive resources that have become redundant in the contracting sectors of the economy are drawn into more efficient employment than before in the expanding sectors and the decline of aggregate output, represented by the horizontal distance between points E and J in the chart, is gradually reversed. The speed at which idle resources are thus absorbed into gainful employment elsewhere depends on many factors, including local infrastructure and institutions and the costs of adjustment and installation of new productive capacity. At any rate, the economy ends up at point F where all profit opportunities have been exploited in full and full employment has been restored at a higher level of output than initially. Output thus follows a J-shaped path, essentially because it takes less time to destroy than to build: unprofitable enterprises can be closed down overnight, but the establishment of new firms to take their place is a more time-consuming process. The ultimate output gain from the intersectoral reallocation of resources is indicated by the thick segment of the horizontal axis. This gain, however, does not reflect more efficient use of those resources within each sector.

The J-shaped response of output to economic reform is reinforced by the effects of the price explosion. This is because the restructuring and stabilization of the economy occur in two phases. Inflation rises at first and then recedes. In the initial phase, inflation jumps as prices that were controlled previously are set free. In this inflationary phase, some financial capital is replaced by physical capital in production. Because physical capital takes time to build and install, output contracts at first as financial capital is removed from the production process, but this output decline is tempered by the gradual accumulation of physical capital. This first phase corresponds to the trajectory of output decline from E to J in Charts 1 and 2. As output declines, unemployment emerges. Sooner or later, however, the second phase sets in as inflation is brought under control and money, credit, and other financial assets are redrawn into the production process. The business opportunities created by stable prices and by a correspondingly favorable business environment will begin to be exploited by profit-seeking entrepreneurs. As aggregate supply begins to recover from AS’ to AS”, inflation begins to recede, and increased price stability will reinforce the expansion of output by improving the allocation and utilization of capital and thereby efficiency. As financial capital begins to grease the wheels of trade and production, the economy moves to the right from the unemployment point J towards point F on the production possibility frontier (not shown) corresponding to maximum efficiency in the allocation and utilization of real and financial capital. Gradual adjustment trajectories of this type involving unemployment of labor and other factors of production can be derived from optimal producer behavior if the adjustment itself is costly (see Mussa 1982).

Even though the output loss from E to J is temporary and the ultimate output gain from J to F is permanent, the adjustment from E to F via J may or may not increase the present discounted value of output because the output loss is suffered before the gain materializes. The cure may conceivably be worse than the disease.

Consider the following three examples:

Example 1. Suppose that output Y_t grows at an exogenously determined annual rate g, then decreases below its growth path by a fixed amount ΔY > 0 from time t = 0 to t = T, and then increases above its original growth path by θΔY from t = T to infinity where θ is some positive constant. Then the present value of the cumulative net output gain during the adjustment period is

which is positive as long as

If, for instance, the temporary loss of output equals one third of the ultimate gain (θ = 3) and the annual discount rate is 8 percent (ρ = 0.08) and the rate of growth is 3 percent (g = 0.03), then the transformation would yield a positive net gain as long as it took 28 years or less. A less favorable gain/loss ratio (say, θ = 1.5), less patience (e.g., ρ = 0.1), and less growth (say, none) would shorten the relevant time horizon: in this case, the output reversal would have to take place within 9 years for the structural adjustment to be worthwhile from an economic point of view.

Example 2. Consider now the following path of the logarithm of output:

where a, b, and c are positive constants and g is the rate of growth of output in the long run. This output path converges on the straight line ln(Y_t) = gt + b as t tends to infinity. The rate of growth converges on g that is exogenously determined here by assumption. The S-shaped curve in Chart 3 illustrates the case where g = 0.04, a = 0.4, b = 0.5, and c = 0.01 in equation (3).

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Exogenous Growth: The First 25 Years

Citation: IMF Working Papers 1994, 071; 10.5089/9781451959888.001.A001

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Along this hypothetical path, output declines initially by 45 percent during the first three years. The decline is gradually reversed, however, and output is restored to its initial level in the eighth year from the beginning of the transformation and catches up with its original linear growth path in the eleventh year. The cumulative loss of output is shown by the area enclosed by the two paths during the first 10½ years. Thereafter, output begins to rise above its initial linear growth path and converges on a parallel path where output is 50 percent higher than initially (because b = 0.5). The pattern of growth is illustrated in Chart 4. In the 20th year, the cumulative output gain begins to outweigh the loss incurred during the first eleven years. ^4/ In other words: given an output decline of forty-five percent during the first three years, the transformation does not begin to bear fruit until the 20th year in this example despite double-digit growth rates for nearly a decade beginning in the sixth year. This is troubling, but a smooth transformation takes time. Different parameter values in equation (3) produce different paths of output, some implying a more abrupt recovery.

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The Pattern Of Growth: The First 25 Years

Citation: IMF Working Papers 1994, 071; 10.5089/9781451959888.001.A001

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Example 3. Imagine now that output grows by 4 percent a year along the ray from the origin in Chart 5 and that structural adjustment and stabilization increase the rate of growth from 4 percent to 6 percent a year ultimately, albeit at the cost of a temporary slump in output as before. This case is illustrated by the S-shaped curve in the chart with g = 0.06 in equation (3); the values of a, b, and c are unchanged. In this case, output recovers after 6½ years, crosses the initial growth path in 9 years, and rises to a level twice as high as it would otherwise have reached in 25 years. ^5/ With a growth differential of 2 percent, output doubles every 35 years compared with the initial growth path, other things being equal. The benefits from increased growth build up.

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Endogenous Growth: The First 25 Years

Citation: IMF Working Papers 1994, 071; 10.5089/9781451959888.001.A001

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These simple examples do not, of course, tell the whole story. In particular, the current generation bears a disproportionate part of the burden of the adjustment. This may reduce public support for the transformation as the unborn generations that would be the prime beneficiaries of a more efficient allocation of resources have no direct influence on the current generation’s choice between structural adjustment and the status quo. Even so, the examples above indicate the importance of attempting a quantitative assessment of the entire adjustment path of output during and after the transition to a market economy. The short-run reaction of output is difficult to deal with analytically, however, because it depends on the complex interaction between aggregate demand and supply and between different sectors of the economy. From now on, therefore, the discussion will focus on the long-run effects of structural adjustment through stabilization.

2. Static gains from stabilization: A simple formula

So how is the ultimate increase in output following stabilization, structural adjustment, and improved allocation and utilization of resources related to the magnitude of the initial inflation problem?

Let there be two types of capital, real and financial, as before. The production function is

with F_K > 0, F_M > 0, F_KK < 0, and F_MM < 0 as usual. One may think of K as tractors, for example, and M as the money balances that are needed to buy spare parts to keep the tractors running. Other factors—labor, land, energy, and so on—are held fixed. Consider two periods, 1 and 2. A firm starts out in year 1 with a given amount of assets A. It buys tractors K for part of this amount to begin production, and keeps the rest as money balances M. Production in year 2 is Y = F[A-M, M/(1+π)] where π is the annual rate of inflation. Real capital retains its value in year 2, but inflation causes financial capital to depreciate. The first-order condition for maximum output is -F_K + F_M/1+π) = 0. Therefore, the equilibrium ratio of the marginal products of M and K is ^6/

Inflation drives a wedge between the marginal products of the two types of capital (see Easterly 1992), and thus reduces the output that can be produced by given total capital. To maximize output, the inflation distortion must be eliminated.

In Chart 6, the initial long-run full-employment equilibrium position is described by point E at which the domestic relative factor price line with slope -(1+π) is tangential to the isoquant corresponding to the maximum level of output (per head because the labor force is fixed) attainable from the initial composition of the capital stock at E. (This point corresponds to its namesakes in Charts 1 and 2.) The flatter line through E with the slope -1 reflects the undistorted factor price ratio that prevails when the inflation rate is zero. This line is tangential at point F to a higher isoquant corresponding to the highest level of output attainable from a more efficient composition of the capital stock at F. This line connecting E and F cuts the vertical axis at point N that indicates national output (i.e., GNP) at factor cost measured in terms of real capital. The parallel price line tangential to the lower isoquant at point G cuts the vertical axis at point Q that shows the initial lower level of output at factor cost, also in terms of real capital.

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Static Output Gain From Stabilization

Citation: IMF Working Papers 1994, 071; 10.5089/9781451959888.001.A001

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The distance between the two points, Q and N, shown by the thick segment of the vertical axis in Chart 6, thus indicates the static output gain from the reallocation of capital from E to F according to the total differential of the production function (4):

where ΔY, ΔK, and ΔM are the changes in output, real capital, and financial capital that take place between E and F. Our next objective is to find the relationship between the increase in output ΔY and the policy-induced reduction of inflation from π to zero (through currency reform, for example) that triggered the output gain.

The static output gain from moving from E to F in Chart 6 depends on the magnitude of the initial inflation distortion, that is, the angle between the two relative price lines where they intersect at point E in the chart, and on the curvature of the isoquant. To see this, first invert the production function by writing K = f(Y, M) where f_M = -F_M/F_K < 0 and f_MM > 0 by assumption. Next, ΔK can be approximated by a second-order Taylor expansion for given Y (say, around point E in Chart 6):

Substituting this into equation (6) yields ^7/

At last, we need to relate the change in financial capital ΔM to inflation. At the initial equilibrium point E in Chart 6 the slope of the isoquant equals the slope of the relative price line:

By linearizing this equation we find that

because Δπ = π when inflation is brought down from π to 0. By squaring equation (10) and substituting the result into equation (8) we obtain

In words, the output gain is, to a second-order approximation, directly proportional to the square of the inflation distortion. This formulation is general, and can be applied to any pair of inputs such as capital and energy, for example. Then equation (8) can be used to derive the output gain from bringing the domestic price of energy up to the world market level, ceteris paribus. A similar quadratic formula for the output gain from economic liberalization can be derived from a two-sector general equilibrium model (see Gylfason 1993). As noted before, these gains reflect only the intersectoral reallocation of resources, but not increased efficiency in the use of those resources within each sector over time. Moreover, the formula abstracts from the distribution of seignorage: it shows the effect of removing the inflation distortion on total output without taking the conceivable consequences of increased public debt or taxation or reduced government spending needed to compensate for the loss of inflation tax revenue into account.

But what can be said about the proportionality factor, -½(F_K/f_MM)?

3. Examples and simulations

To make the simple formula (11) operational as a rough guide to the potential magnitude of the responsiveness of output to structural adjustment and stabilization, it is necessary to assume the production function to take a particular form.

Consider, for example, the following CES function:

where the distribution parameter α is a positive constant between 0 and 1 and β = 1 - 1/σ where σ is the constant elasticity of substitution of real for financial capital. In this case, the optimal reaction of producers to reduced inflation is to raise output according to

where

The proportional increase in output brought about by a more efficient utilization of capital because of less inflation is thus approximately proportional to the square of the initial inflation distortion. The proportionality factor, in its turn, is a well-defined function of the parameters of the production function: the elasticity of substitution σ; the distribution parameters α and 1-α; the real capital/output ratio, K/Y; and the optimal ratio of financial to real capital, M/K. Notice also that K/Y can be expressed as a function of M/K by the production function (12), so that λ then becomes a complicated function of α, σ, and M/K alone by equation (14).

The simple formula (13) makes it possible to map the expansion of output ΔY/Y as a function of the underlying parameters of the production structure, factor proportions, and the initial inflation distortion. In particular, the more severe the original inflation distortion π, the larger is the correction that is needed and, hence, the greater will be the gain in output. In short, if the proportional expansion of output is denoted by E, the multiplicative proportionality factor by m, and the constant inflation distortion by c, we have E = mc².

In the special case where σ = 1, the CES production function (12) boils down to a Cobb-Douglas function: Y = AK^αM^1-α where A is a constant of integration. The expression for the proportionality factor in equation (14) simplifies accordingly to

b. Numbers

To illustrate the possible macroeconomic and empirical significance of price stabilization through increased efficiency in the use of capital, let us now proceed to plug some parameter values into our formula (13) in an attempt to provide a glimpse of the possible magnitudes involved. This is inevitably a highly speculative exercise in view of the simplicity of the formula and of the unavailability of hard evidence on the explanatory parameters. The example that follows is meant as an illustration only.

Let us assume that domestic inflation is initially between 10 percent and 1,000 percent a year. This range of values seems reasonable for the purpose of the exercise because inflation has been measured in tens and hundreds of percent annually in many Central and Eastern European countries since 1990. The ratio of financial and real capital in equilibrium is determined by the first-order condition for maximum output (or profit):

$\begin{array}{cc}\frac{M}{K}={\left[\right(\frac{\alpha }{1-\alpha }\left)(1+\pi )\right]}^{-\sigma }& \left(16\right)\end{array}$

The distribution parameter α is assumed to be 0.8. This is consistent with a financial capital/output ratio of M/Y = 0.33 and a real capital/output ratio of K/Y =1.32, so that M/K = ¼ if σ = 1 and π = 0, for instance. The elasticity of substitution σ is assumed to range in four steps from 0.25 to 2.0.

The proportional output gains that follow from these assumptions are illustrated in Chart 7. The schedules in the chart indicate that the static output gains from stabilization can be considerable at high rates of inflation. The thick schedule at the top of the chart shows that the elimination of 250 percent annual inflation increases output by 4 percent when σ = 1, for instance. These gains are permanent, other things being equal. ^8/ The financial capital/output ratio rises from 0.12 to 0.33 in this case as more financial assets are drawn into production when inflation goes down, and the real capital/output ratio falls from 1.70 to 1.32. When α is lowered from 0.8 to 0.7, the output gain from eliminating 250 percent inflation increases from 4 percent to 5 percent. When α is raised to 0.9, on the other hand, the output gain from the same experiment falls to 2 percent. The output gains are smaller when σ equals ½ or ¼ because firms then have less scope for replacing physical by financial capital when inflation goes down. The gains are also smaller when σ equals 1½ or 2 for then the amount of financial capital involved in production is small anyway.

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Static Output Gains From Stabilization

Citation: IMF Working Papers 1994, 071; 10.5089/9781451959888.001.A001

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These results must not be taken too literally, however, for three main reasons. First, they include only the effects of the reallocation of real and financial capital in production, but not of increased efficiency in the use of each type of capital. Second, they do not reflect the possible fiscal ramifications of price stabilization. Third, if the product cycle is short and if product prices rise with inflation, then financial capital will be replenished more quickly (and smaller as well) and its depreciation will be reduced. The first qualification suggests that the effects shown in Chart 7 may be too small, whereas the third suggests that they may be too large; the second one could move the effects in either direction, probably downwards. Even so, if the numbers above provide an indication of the results that would emerge from detailed empirical case studies, it seems reasonable to conclude that economic stabilization can improve allocative efficiency and, over time, increase output substantially and permanently in individual enterprises and in the economy as a whole.

1. Growth with a fixed saving rate

The CES production function (12) means that output is proportional to a bundle of real and financial capital. This implies constant returns to the capital bundle. The labor force remains constant by assumption. Suppose, moreover, that saving S is proportional to output (as in Solow 1956), and equals the net accumulation of both types of capital plus depreciation. Then we have S = sY = ΔK + ΔM + δK + [π/(1+π)]M. Here s is the saving rate that is constant by assumption, δ is the annual rate of depreciation of real capital, and π/(1+π) similarly reflects the rate at which financial capital “depreciates” because of inflation. ^9/

Along the long-run steady-state equilibrium growth path of the economy, output must expand at the same rate as total capital net of depreciation d, so that ΔY/Y = sY/(K+M) - d. This means that

where g = ΔY/Y is the rate of growth, E = Y/(K+M) reflects the efficiency of capital, broadly defined, and

is a weighted average of the two rates of depreciation, δ and π/(1+π), both of which are bounded by 0 and 1.

Therefore, economic growth in the long run depends crucially on the saving rate, the efficiency of capital, and depreciation by equation (17). Put differently, growth depends on the quantity and quality of capital. Equation (17) is essentially a restatement of the economic growth theory of Harrod and Domar.

Generally, E reflects the efficiency of resource allocation in the economy. By implication, all improvements in efficiency, including those resulting from price reform, privatization, trade liberalization, education, research and development (as in Grossman and Helpman 1991), and so on, lead not only to a higher level of output once and for all, as we know, but also to a higher rate of growth of output over time by equation (17). This is why the economy follows the path EJHFI rather than EJHFK in Chart 1. The shaded area FIK represents the dynamic output gain from economic reform, including even price stabilization.

This can be seen by first dividing through the production function (12) by real and financial capital, K+M, to find:

An increase in the ratio of financial to real capital, M/K, can be shown by differentiation to increase efficiency as long as M/K < [α/(1-α)]^σ, that is, as long as inflation remains above zero by equation (16). A decrease in the inflation rate increases M/K by equation (16) as long as σ > 0, and thus increases the efficiency of capital by equation (19) and thereby also economic growth by equation (17) provided that π > 0 at the outset. Moreover, a decrease in inflation generally stimulates growth by slowing down the depreciation of the financial part of the capital stock.

Less inflation leads to more growth in this model essentially because the disinflation reduces a distortion in production (as in Easterly 1992).

The resulting increase in growth is permanent by the construction of the CES production function (12). Specifically, the mechanisms that prevented increased efficiency and increased saving from stimulating growth permanently in the models of Harrod and Domar and Solow are absent here because the production function (12) exhibits constant returns to capital, broadly defined (as in Romer 1986, 1989).

Even so, a link between efficiency and growth is present in the neoclassical growth model. There, as here, increased price stability can be shown to increase the output that can be produced from given inputs, and thus to be tantamount to technical progress that increases the growth of output while the economy moves from one steady-state growth path to another, higher path. This adjustment process can take a long time. The medium-term properties of the neoclassical model of Solow may thus be difficult to distinguish empirically from the long-run properties of the Romer version of the endogenous-growth model employed here.

2. Growth with a variable saving rate

Thus far, saving behavior has been assumed to be unaffected by inflation and other aspects of the economic environment. This is an unrealistic assumption, especially if inflation is high initially. So how does the model change if the saving rate is variable?

Let us suppose that consumers choose a path of consumption C_t that maximizes their utility U_t over time. Specifically, they maximize the integral $\underset{0}{\overset{\infty }{\int }}{U}_t\left(C_t\right)e^{-\rho t}dt,$ where ρ is the discount rate as before, subject to the constraint that gross investment equals output less consumption and the accumulation of financial capital, that is, ΔK + δK = Y - C - ΔM - [π/(1+π)]M. Using Y = E(K+M) from equation (17), we see that Δ(K+M) = E(K+M) - δK - [π/(1+π)]M - C = (E-d) (K+M) - C by equation (18). Suppose that the utility function is isoelastic, U_t = C_t^1-1/θ/(1-1/θ), where θ is the elasticity of intertemporal substitution. Then the present discounted value of utility over time is at a maximum when

Here g is the rate of growth of consumption and real and financial capital and, therefore, also of output along the optimal consumption path. ^10/

Equation (20) is the standard solution to the Ramsey problem except E now plays the role of the marginal product of capital and d is a composite of the depreciation rates of the two types of capital.

Equations (17) and (20) can now be solved for the optimal propensity to save:

The optimal saving rate is constant for given θ, ρ, d, and E. ^11/ The two taste parameters, θ and ρ, have predictable effects on saving. Increased patience, that is, a reduction in ρ, raises the saving rate because ∂s/∂ρ - θ/E<0. Increased flexibility in consumption over time, that is, an increase in Θ, also boosts the saving rate because ∂s/∂θ = 1 - (d+ρ)/E which is positive as long as the growth rate is positive by equation (20).

Inflation affects saving behavior through efficiency and depreciation, E and d. Consider first the simple case where the elasticity of intertemporal substitution is one (θ = 1). This means that the utility function is logarithmic. Then the optimal saving rate is s = 1 - ρ/E by equation (21). Increased inflation lowers the saving rate unambiguously in this case by reducing efficiency, compare equations (16) and (19). When θ > 1, the negative effect of increased inflation on saving is reinforced by more rapid depreciation: consumers then respond to increased financial depreciation by saving less. When θ < 1, however, consumers react to increased financial depreciation by saving more. In this case, the net effect of increased inflation on saving through efficiency and depreciation is ambiguous. This is the most relevant case when consumers face severe borrowing constraints in financial markets, as they do in Central and Eastern Europe, and the flexibility of consumption over time is correspondingly restricted.

In sum, then, inflation affects economic growth not only through efficiency and depreciation, but also through saving when the saving rate is variable, compare equation (17).

3. Numerical simulations

How strong are the links between inflation and growth that have been outlined above? It now remains to attempt to quantify the potential dynamic gains from macroeconomic stabilization.

Charts 8 and 9 illustrate the relationship between inflation, efficiency, and saving when the elasticity of intertemporal substitution θ = 0.2, the discount rate ρ = 0.1, and the distribution parameter α = 0.8, compare the production function (12). The elasticity of substitution of real for financial capital σ spans the range from 0.25 to 2.0 as before. The benchmark case with σ = 1 is distinguished by the thick schedules in the charts. In this case, as inflation rises from zero to 1,000 percent per year along the horizontal axes in the charts, the financial capital/output ratio M/Y decreases from 0.33 to 0.05 and the real capital/output ratio K/Y increases from 1.32 to 2.13. This means that the ratio M/K collapses from 0.25 to 0.02. The total depreciation rate d rises from 0.08 at zero inflation to 0.15 at 150 percent inflation, and then declines gradually to 0.12 as inflation approaches 1,000 percent per year and the depreciable stock of financial capital decreases, compare equation (18). The optimal saving rate rises at first from 0.27 at zero inflation to 0.37 at 200 percent inflation to meet the increased depreciation of financial capital, and then stabilizes at 0.36 as the increase in depreciation is reversed (Chart 8). On the other hand, efficiency (i.e., the average productivity of total capital) decreases uniformly from 0.61 to 0.46 as inflation increases from zero to 1,000 percent (Chart 9).

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Inflation And Saving

Citation: IMF Working Papers 1994, 071; 10.5089/9781451959888.001.A001

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Inflation And Efficiency

Citation: IMF Working Papers 1994, 071; 10.5089/9781451959888.001.A001

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The positive relationship between the saving rate and inflation at or below 200 percent a year has been built into the simulation by assuming the intertemporal elasticity of substitution θ to be far below unity to reflect borrowing constraints in the banking system. An elasticity of substitution at or above unity would produce a uniformly negative relationship between inflation and the saving rate, other things being equal. It would also entail a very high saving rate (s = 0.84 if θ = σ = 1.0 and π = 0) in this model and a growth rate to match (g = 0.43) because of the farsightedness of fully rational consumers that live forever and can borrow and lend at will in a flexible banking system.

Inflation influences growth by equation (20), through E and d. Growth can also be viewed as being influenced by inflation through saving, efficiency, and depreciation by equation (17). Either way, the effect is indeterminate in theory. The relationship between inflation and growth is illustrated in Chart 10 for different values of the elasticity of substitution of real for financial capital. The optimal growth rate is directly related to the elasticity of substitution in production at any given rate of inflation: the more flexible the production structure, the higher is the rate of growth.

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Inflation And Growth

Citation: IMF Working Papers 1994, 071; 10.5089/9781451959888.001.A001

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Inflation and growth are also inversely related throughout. If σ = 1, for example, reducing inflation from 250 percent a year to zero raises the optimal rate of growth of output from 6 percent to almost 9 percent per year through the combined effect of greater efficiency (from E = 0.55 to E = 0.61) and reduced depreciation (from d = 0.14 to d - 0.08), even though the saving rate falls from 0.37 to 0.27 in this process, compare Chart 8. A growth bonus of 3 percent a year makes a difference: it doubles output every 23 years, other things being equal. The dynamic gains from stabilization are inversely related to the elasticity of substitution in production: the more rigid the production structure, the lower is the initial rate of growth at any given rate of inflation and, therefore, the greater is the growth bonus due to stabilization.

But what if the saving rate is held fixed by short-sighted consumers at, say, s = 0.2? Then the growth rate rises from -3 percent to 4 percent when inflation is brought down from 250 percent to zero. The dynamic output gains are greater when the saving rate is fixed because an optimally determined saving rate is reduced in response to the eradication of inflation when the elasticity of intertemporal substitution θ is low, compare Chart 8. If θ is high, on the other hand, the saving rate rises when inflation goes down: in that case the dynamic gains from stabilization are greater than when the saving rate is flexible.

In sum, these simulations indicate that economic stabilization may bring substantial dynamic gains through growth on top of the static gains discussed in the preceding section. This is a matter that calls for close econometric scrutiny in future work on inflation and growth (see Fischer 1991).