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The author would like to thank Charles Adams, Michael Hadjimichael, Robert Kahn, Carmen Reinhart, Federico Rubli-Kaiser and Alessandro Zanello for helpful comments and suggestions.
As capital becomes less mobile, however, the current account growth reaction to an exchange rate-based stabilization will diminish and perhaps even change sign. Also when capital is not mobile, while the income growth reaction to an exchange rate-based stabilization will become more negative, it is a positive reaction when indexation is mostly forward-looking, and therefore some backward-looking wage indexation could stabilize income after an announcement of an exchange rate-based program.
The program might also lack credibility in a different way; it could be believed that a recession would cause the authorities to abandon the price stabilization effort and increase the rate of crawl of the exchange rate (α < 0). This possibility is examined later in the section where different scenarios of price stabilization efforts are presented.
Not explicitly modeled here is the fact that changing δ will reduce β, in other words increasing the backwardness of indexation will reduce expectations of any reduction in inflation. The exact response of β to δ will depend on how knowledgeable the public is about how the rate of inflation is determined. The limiting case is the one where the public has full information about all coefficients in the model and about the probability density functions of the shocks, in which case β will be between zero and α. If β reacts strongly to changes in δ, the effects of changing δ on the coefficients may be greater than in the case of static expectations.
It is most likely true that d2/d1 < c2 + λc1(βt+1-1) since otherwise the indirect effect the growth of the exchange rate has on the growth of the current account by affecting income growth would be larger than the direct effect it has by the changing relative price growth of exports and imports. This would also be contrary to the experience of countries that have used exchange rate-based stabilization programs.