Working Paper: NBER ID: w8706
Authors: Roberto Rigobon
Abstract: During the last two decades, many Latin American countries engaged in disinflation programs based on both exchange rate management and fiscal reforms. However, in most instances, part of the fiscal reform was delayed or not implemented completely, so the fiscal deficit increased and the program had to be abandoned. The aftermath of these programs is not encouraging, since most of these policies turned out to be failures, lowering reserves and causing higher inflation rates. Given this record, it is worth asking why governments start a disinflation program even though the fiscal equilibrium is not guaranteed. In this paper we show that, if the reform process is uncertain and inflation has welfare costs, the optimal exchange rate policy implies the initiation of a disinflation program at the announcement of the fiscal reform. Additionally, we show that even if there exists a possibility of a balance of payments crisis, it is still optimal to initiate a disinflation program. This means that, in this set up, avoiding the crisis with probability one is suboptimal. Finally, we show that it is optimal to engage in a sequence of stabilization programs until one of them is successful.
Keywords: No keywords provided
JEL Codes: F31; F32; E13; E4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| announcement of fiscal reform (H69) | initiation of disinflation (E31) |
| risk of a balance of payments crisis (F65) | initiation of disinflation (E31) |
| sequence of stabilization attempts (C62) | eventual success (P17) |