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The recession typically associated with disinflation programs appears only later in the programs. Second, money-based stabilization leads to an early recession, suggesting that the timing of the contraction depends on the nominal anchor which is used (the ”recession-now-versus-recession-later” hypothesis). We did not, however, find support for the existence of an investment cycle in exchange rate-based stabilizations. Nor did we find evidence of a significant fall in public consumption around the time of stabilization.

We then reviewed the main theories aimed at explaining these puzzles. We first focused on theories that emphasize expansions in demand: inflation inertia, lack of credibility (temporary policy), and durable goods. The first, inflation inertia, relies on an fall in real interest rates to generate the initial boom. However, within an optimizing framework and in the absence of any wealth effect, this theory would require some implausible parameter configurations to rationalize the initial boom. If you are interested in payday loans similar to speedy cash, then we have great news for you. Our loans are just as dependable and transparent, but they will cost you much less, because we are trying to be competitive. Apply for your loan at review and see how advantageous it is to borrow from us!

Also, it would have a hard time explaining the boom in programs in which real interest rates rise on impact. The second, lack of credibility, conforms quite well with the stylized facts. Quantitatively, however, it faces the problems of low intertemporal elasticities of substitution. The third, which relies on the timing of purchases of durable goods, may also reproduce the consumption cycle. Its quantitative relevance has not been evaluated yet.

We then turned to explanations that rely on wealth effects. The first emphasizes supply-side responses — both in labor supply and investment — to the removal of the inflation distortion. While these theories can explain the boom, they cannot explain the late recession. In addition, the fact that the investment cycle was not found significant casts some doubts on the relevance of this mechanism. A second source of wealth effects — cuts in government spending — faces a similar problem. Quantitatively, however, supply-side effects appear to be a critical component of any story aimed at explaining the empirical regularities associated with exchange rate-based stabilization.

To explain the stylized facts of money-based stabilization, we resorted to an optimizing version of traditional sticky-prices model a la Taylor-Fischer. A reduction in the rate of money growth decreases expected inflation and thus the nominal interest rate. This induces an incipient excess demand for real money balances. To restore money-market equilibrium, consumption (and thus output) of home goods needs to fall.

This is effected through a real appreciation of the domestic currency. It is worth stressing that sticky prices are essential to this type of model. Without this feature, money-based stabilization would yield the same results as exchange rate-based stabilization. Hence, a model designed to explain both the stylized facts of exchange rate-based and money-based stabilization — and, in particular, the recession-now-versus-recession-later hypothesis — requires sticky prices and an interest-rate elastic money demand (see Calvo and Vegh (1994c)).

Since most exchange rate-based stabilizations end in full-blown balance of payment crises — typically accompanied by banking crises — we took a detailed look at both the mechanics and causes of balance of payments crises in the final leg of our journey (Section 7). While the starting point of this section was Krugman’s (1979) seminal paper on balance of payments crises, most of the issues touched upon have come to light after the December 1994 Mexican crisis, and represent very much research in progress.

It was argued that simple extensions of Krugman’s (1979) model may account for some missing links in the original story: (i) bond-financing may mask the fiscal problems by preventing reserve losses; (ii) imperfect substitutability between domestic and foreign assets opens the door for the central bank to sterilize the effects of reserve losses on money supply; and (iii) an active interest rate policy allows the central bank to postpone the abandonment of the peg and avoid a run in the final stages.