Front Matter Page
Research Department
Contents
Summary
I. Introduction
II. A Vector-Autoregression Model for Uruguay
1. Time-series properties
2. Lag length
3. Estimation
III. Impulse Response
1. Exchange rate-based stabilization
2. Money-based stabilization
3. Robustness of results
4. The role of Argentina
IV. Econometric Issues
1. Underlying economic mechanisms
2. Temporary versus permanent shocks
3. Cooley and LeRoy’s critique
4. The Lucas critique
5. How important are nominal shocks in Uruguay?
V. An Economic Interpretation
1. Money-based stabilization
2. Exchange rate-based stabilization
a. Backward-looking behavior
b. Models that rely on wealth effects
c. Models that rely on temporary policy
VI. Final Remarks
Text Tables
1. VAR Estimates, Constrained and Unconstrained, 62 Observations from 1975:Q3-90:Q4
2. Variance and Historical Decompositions of Cyclical Output
Figures
1. Uruguay: Inflation Rate 1940-94
2. Exchange Rate-Based Stabilization
3. Money-Based Stabilization
4. Narrow Monetary Aggregates
Appendix I. Supportive Econometric Evidence
1. Data source and sample
2. Time-series properties
3. VAR lag length
4. Contemporaneous correlation matrix
5. Ordering of the variables
6. Coefficient stability
7. Alternative exogenous variables
8. Monetary regimes in Uruguay since 1972
a. Passive crawling-peg (March 1972-October 1978)
b. Tablita period (active crawling-peg) (October 1978-November 1982)
c. Floating period (December 1982-fourth quarter of 1985
d. Managed floating (fourth quarter of 1985 through end of 1990)
e. January 1991 stabilization plan (active crawling peg)
Appendix Tables
A1. Unit Root, Lag Length Tests and Contemporaneous Correlations
A2. Output Impulse Responses to Exchange Rate Stabilization
A3. Output Impulse Responses to Money Based Stabilization
A4. Likelihood Ratio Tests for Coefficient Stability
A5. VAR Estimates, Using Bilateral Real Exchange Rate with Argentina (Q) and Terms of trade (TOT), 62 Observations from 1975:Q3-90:Q4
Appendix Figures
A1. Temporary Exchange Rate-Based Stabilization Alternative Exogenous variable
A2. Temporary Money-Based Stabilization Alternative Exogenous Variable
References
Summary
Casual empiricism suggests that the timing of the recessionary costs associated with an inflation stabilization program depends on the nominal anchor used. While under money-based stabilization the recession occurs in the early stages of the program, under exchange rate-based stabilization the recession appears to take place in the late stages of the program. The choice of a nominal anchor would thus entail a choice between recession now (money anchor) or recession later (exchange rate anchor).
This paper offers empirical evidence on the “recession-now-versus-recession-later” hypothesis for the case of Uruguay, a chronic inflation country. Formally, the paper estimates a vector-autoregression model (VAR), which includes the rate of depreciation, the rate of monetary growth, inflation and output, and controls for Argentina’s influence on the Uruguayan economy. This VAR model is used to simulate the output response to both a money-based and an exchange rate-based stabilization. Technically—and departing from standard practice—the model is subjected to a series of innovations of the policy variable to ensure that it follows a predetermined path.
The impulse responses for output indicate that a money-based stabilization results in an initial contraction, while a (temporary) exchange rate-based stabilization leads to an initial expansion followed by a later contraction. The econometric evidence is thus broadly consistent with the recession-now-versus-recession-later hypothesis. Furthermore, the evidence suggests that the high degree of dollarization of the Uruguayan economy may hinder severely the effectiveness of a monetary anchor.