We studied the effects of a credible money-based stabilization program under a flexible exchange rate regime in the context of New-Keynesian dynamic general equilibrium model for a small open economy. In this study, we successfully replicated the main stylized facts of money-based stabilization, a slow inflation convergence and an initial recession in domestic sector. In contrast with the previous results, however, a credible money-based disinflation in this model produces a sustained expansion in domestic sector after the initial contraction.
Money-based stabilization is an inflation stabilization policy based on reduction of the rate of growth of the money supply under a flexible exchange rate regime. Money-based stabilization programs have been widely used in chronic inflation countries.
However, money-based programs have been much less common than the use of an exchange rate in chronic inflation countries.1Robelo and Végh, 1995 and Calvo and Végh, 1999 provide a number of reasons for the exchange rate to be a preferred anchor. First, since the velocity of money may be unstable during the stabilization, it is difficult for a policymaker to determine the appropriate growth rate of the money supply in practice. Second, in the transition from high to low inflation, the economy may experience a period of deflation. Thus, policymaker will engineer a one-time increase in the money supply to avoid deflation, which weakens the policymaker’s credibility.
However, there are several reasons for analyzing money-based stabilization in this paper. First, stabilization programs supported by the use of IMF resources have been usually money-based programs.2 Because most exchange rate-based stabilizations end up in balance-of-payment crises,3 there is a need to find possible policy instruments to bring down high inflation without triggering crises. It should be noted that many exchange rate-based stabilization programs have failed.4 Therefore, for a country which experienced a series of failed exchange rate-based programs, it could be wise to switch the anchor.
In this study, we analyze the money-based stabilization program in the context of a New-Keynesian dynamic general equilibrium model for an open economy where the rate of inflation is sticky. Our model is based on Obstfeld and Rogoff’s (1995) “Exchange Rate Dynamic Redux”. We modify Obstfeld and Rogoff’s model in several ways. We assume a small open economy with two sectors (tradable and non-tradable). Money is introduced by a cash-in-advance constraint, which generates the monetary wedge. We also incorporate backward-looking indexation into the model to explain the slow convergence of the rate of inflation.
From this study, we are able to replicate the stylized facts of the money-based stabilization programs, a slow inflation convergence and an initial recession in domestic sector. This result is consistent with empirical and theoretical regularities documented by Calvo and Végh, 1999 and Fischer, 1986. In contrast to previous results, however, the analysis shows that the credible reduction in the money growth rate produces the sustained expansion of the domestic sector after an initial recession. Another distinguishing feature of this study is that sometime over the adjustment period the rate of inflation is below the new growth rate of the money supply. Therefore, it is not necessary for a policy maker to increase the money supply to avoid deflation during the stabilization. However, the welfare implications of permanent reduction in inflation are ambiguous.
This paper proceeds as follows. In Section 2, we propose a standard dynamic general equilibrium model for a small open economy in the ways described above. Section 3 discusses the effects of a credible money-based disinflation policy, and the last section concludes.
In this paper, we study money-based stabilization in the context of a New-Keynesian dynamic general equilibrium model for an open economy where the rate of inflation is sticky.
This study successfully replicated the main stylized facts of money-based stabilization, a slow inflation convergence and an initial recession in domestic sector. The rate of inflation converges slowly to the growth rate of the nominal anchor and a non-tradable sector shows a sharp and short-lived contraction after the implementation of a money-based program. The initial contraction after the stabilization attempt is typical of disinflation programs when the money growth rate is used as a nominal anchor. This result is broadly consistent with empirical and theoretical regularities documented by Agénor and Montiel, 1999, Calvo and Végh, 1999 and Fischer, 1986. It is also consistent with the notion that disinflation is contractionary in industrial countries (Gordon, 1982). However, a credible money-based disinflation in our model produces a sustained expansion in domestic sector after the initial contraction. This result stands in sharp contrast with the previous results. Also, the sustained expansion in the domestic sector comes with a slow convergence of inflation.
Another distinguishing feature of this study is that sometime over the adjustment period the rate of inflation is below the new growth rate of the money supply. Therefore, it is not necessary for a policy maker to increase the money supply to avoid deflation during the stabilization.
The welfare implication of the model is ambiguous. In the new steady state, the higher non-tradable consumption increases the welfare. However, it is not clear that the long-run effect overweigh the initial welfare effect by a reduction in non-tradable consumption, and the demand for leisure of the household in the new steady state is less than at the initial level. This also has a negative effect on welfare.14
