Working Paper: NBER ID: w2268
Authors: Allan Drazen; Elhanan Helpman
Abstract: Stabilization programs in open economies typically consist of two stages. In the first stage the rate of currency devaluation is reduced, but the fiscal adjustment does not eliminate the fiscal deficit which causes growth of debt and loss of reserves, making a future policy change necessary. Only later, at a second stage, is this followed by either an abandonment of exchange rate management or by a sufficiently large cut in the fiscal deficit. We study how different second-stage policy changes affect economic dynamics during the first stage. These changes include tax increases, budget cuts on traded and nontraded goods, and increases in the growth rate of money. Under certainty about the timing and nature of a switch, current account developments provide information about which policy instrument is expected to be used for stabilization. Uncertainty about the timing of a stabilization is shown to be important in explaining phenomena such as continuous reserve losses and the possibility that a policy change is accompanied by a surprise discrete devaluation rather than a run on reserves.
Keywords: Exchange Rate Management; Stabilization Programs; Economic Dynamics; Timing Uncertainty
JEL Codes: E63; F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Second-stage policy changes (like tax increases or budget cuts) (E65) | Economic outcomes (like reserve losses or devaluations) (F65) |
| Uncertainty about the timing of stabilization (E63) | Economic behavior (such as reserve management and exchange rate adjustments) (F31) |
| Uncertainty about the timing of stabilization (E63) | Run on reserves (E58) |
| Uncertainty about the timing of stabilization (E63) | Discrete devaluations (F31) |
| Shifts in policy instruments under uncertainty (E61) | Variations in economic outcomes (F61) |
| Uncertainty about the timing of stabilization (E63) | Surprise devaluation (F31) |