Stabilization programs often include a fixing of the exchange rate. One of the theoretical justifications for this can be found in the literature on policy games. In that context, it has been shown that time-consistent inflation would be lower with a fixed exchange rate system rather than a free float system where purchasing power parity always holds. However, when a stabilization program is implemented, there is often great uncertainty about the policymakers’ intentions and some authors have identified these information asymmetries between the government and the public as a possible cause of the slow decline in inflation.
This paper challenges this view. It analyzes the consequences on the actual and expected inflation rate of a shift from a floating rate regime--where purchasing power parity always holds--to a pegged exchange rate regime, in an environment of asymmetric information. The framework of the analysis is a policy game in which policymaking is endogenous and the public learns rationally.
The paper presents two main findings. First, that there is a “honeymoon effect” after the regime change, where inflation is lower than in the long run. Second, that the asymmetric information outcome converges to that of symmetric information in the long run. Hence, the paper concludes that information asymmetries are not responsible for lengthy disinflations. Rather, the private sector’s uncertainty about government preferences results in lower time-consistent inflation than that prevailing once private agents have learnt the policymakers’ preferences.