This paper focuses on the supply-side effects of disinflation programs, an aspect of these programs that has been largely neglected in the literature. Although the results are based on some Latin American countries’ programs, the introduction of supply-side factors is useful in understanding stabilization programs in Eastern Europe and the former Soviet Union where high inflation and structural changes are likely to coexist.
The paper considers an economy where a tradable good is produced using reproducible capital and labor, and a nontradable good is produced using land (that is, nonreproducible capital) and labor. This asymmetry in the reproducibility of the specific factors captures the slower medium-run response of the supply of nontradables. The tradable sector responds more flexibly through the importation of machinery and equipment compared to a nontradable sector that requires relatively more investment in infrastructure.
In this framework, inflation generates a wedge between the real return of foreign assets and that of domestic assets—money, capital, and land--owing to the cash-in-advance constraint. An exchange rate-based stabilization program reduces this wedge and leads to a higher desired capital stock. In the short run the capital stock is fixed, but an increase in aggregate demand causes a real exchange rate appreciation, an expansion in the production of nontradables, and a boom in land prices. As the new capital is installed it draws labor away from the nontradable sector, leading to further real exchange rate appreciation. The consumption and investment booms lead to a deficit in the current account of the balance of payments, which is gradually reduced as the production of tradables grows over time. It is worth noting that over the medium run the economy experiences a persistent real exchange rate appreciation together with an improvement in the trade balance. This suggests that commonly held notions of competitiveness and sustainability of external deficits may be misleading, especially when the stabilization program has achieved a reasonable degree of credibility.
Some evidence on these supply-side effects from the Argentine and Mexican stabilization programs is presented. In particular, both countries show a remarkable (at least fourfold) increase in imports of capital goods, the driving force of the model under study. This confirms existing evidence of the negative effect that inflation has on capital formation, which has consequences not only for the long run but also for the transitional periods that are the subject of the paper. There is also some evidence of an increase in labor force participation and hence in labor supply.