Exchange-Rate Based Inflation Stabilization: The Initial Real Effects of Credible Plans

Abstract

This paper presents a dynamic general equilibrium model of a small, open, monetary economy in order to analyze the short-run effects of credible stabilization plans that fix the nominal exchange rate in a regime of free convertibility. In this model inflation acts as a tax on domestic market transactions. In particular, it generates a wedge between the rate of return on investment in domestic capital and the rate of return on investment in foreign assets. The model stresses the importance of adjustment costs (including gestation lags) in explaining the precise character of the initial dynamics. The main stylized facts of this type of programs namely an initial phase characterized by several months of real exchange rate appreciation, trade balance deterioration and expansion in aggregate demand and production, followed by a deflationary slowdown in real activity, are replicated without resorting to credibility problems, sticky prices, adaptive expectations, or gradual disinflation schemes. Finally, the model is calibrated using long-run relations from the Argentinean economy, and its quantitative predictions are compared to the initial effects of that country's Convertibility Plan of April 1991.

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