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Exchange rate based stabilization : tales from Europe and Latin America (English)

There is convincing empirical evidence that the cycle for exchange-rate-based disinflation in high-inflation Latin American economies typically begins with expansion and ends in recession - a surprising pattern. The authors explore whether a similar cycle can be observed in exchange-rate-based disinflation in low-inflation economies. They draw on empirical evidence from stabilizaton programs in three European countries in the early 1980s: in Denmark (1982), Ireland (1982), and France (1983). In these programs, the authorities fixed the central parity of the exchange rate band against the European currency unit (ECU). This represented a break from previous years when this rate was often realigned to accommodate inflation. They find that the Irish and French programs followed the more traditional pattern. In the initial phase, there was a recession accompanied by a continuous, gradual reduction in inflation - followed by a second, more expansionary, phase. The initial recession was attributable to a lack of credibility about the pace of disinflation (reflected in an increase in real wages) and a reduction in aggregate demand resulting from tight monetary and fiscal policies. Stabilization in Denmark, on the other hand, was expansionary. The key question is whether this expansion was similar to that in the high-inflation Latin American economies, in origins and characteristics. It has been argued that expansion in the high-inflation economies was caused by the perception that the program was temporary. Expectations of a future reversal led to an increase in spending and output. By contrast, expansion in Denmark appears to have been driven by opposite forces - by overconfidence about the speed of disinflation. These findings support the view that the high-inflation economies are a group to themselves. In particular, disinflation in these economies is likely to face obstacles inherently different from those observed in most industrial, low-inflation countries. In addition, the costs of exchange-rate-based disinflation are typically experienced at different times. The recession appears upfront in industrial countries, and at a later stage in the high-inflation economies.

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Citation

Ades, Alberto F. Kiguel, Miguel Liviatan, Nissan

Exchange rate based stabilization : tales from Europe and Latin America (English). Policy, Research working papers ; no. WPS 1087. Transition and macro - adjustment Washington, D.C. : World Bank Group. http://documents.worldbank.org/curated/en/643451468770970477/Exchange-rate-based-stabilization-tales-from-Europe-and-Latin-America