Essays on the Real Effects of Exchange Rate-Based Stabilizations

Exchange rate crises in Latin America recently put a spotlight on the perils of Exchange Rate-Based Stabilizations (ERBS), which use the nominal exchange rate as the main policy target for stabilizing inflation. This dissertation documents the effects of ERBS in high inflation economies and develops models to explain these stylized facts. The first chapter assesses the empirical regularities associated with ERBS. Based on a sample of 13 stabilization episodes, typical real and monetary dynamics are investigated in Burns-Mitchell diagrams. Stylized facts of ERBS are the initial increases in consumption and GDP, the real appreciation and the current account deterioration. Moreover, consumption and output are found to follow a boom-slowdown cycle, where slowdown means reduced or zero growth if the ERBS is still in effect, and negative growth rates for failed ERBS. Capital inflows follow a similar boom-bust cycle: Their increase at the stabilization’s inception is followed by a sharp reversal three to six years later, very often coinciding with the program’s collapse. This transitoriness of ERBS constitutes an additional stylized fact: 70 % of the programs under consideration failed within 10 years after their implementation. The origin of the initial real exchange rate appreciation during ERBS has been subject to controversy: Most models assume an increase in the relative price of non-traded goods. Empirical findings, in contrast, emphasize the contribution of traded goods’ cross-country prices. Chapter 2 sheds light on this issue by applying Engel’s (1995) method of variance decomposition on Brazilian-US real exchange rate fluctuations. The results confirm both the models and the empirical findings: When considering the full sample (from January 1981 to May 2001), changes in traded goods’ prices and the nominal exchange rate account for almost all of the observed real exchange rate movements. During periods of pegged exchange rates, however, non-traded goods’ prices are equally important for real exchange rate fluctuations. Thus, changes in relative non-tradables’ prices are incorporated as a determinant of real exchange rate fluctuations during ERBS in the theoretical frameworks presented in chapters 3 and 4. These explain the stylized facts in models of small, open economies populated by a utility-maximizing representative agent endowed with perfect foresight. Money matters due to cash-in-advance constraints. Further important features are the existence of market imperfections – price stickiness or imperfect capital mobility – and the stabilization’s deficient credibility. In chapter 3, the latter is due to the anticipation of a Krugman (1979)-style currency crisis. The initial real appreciation during ERBS can then be explained with forward-looking price setting by monopolistic non-tradable goods’ producers: These are subject to staggered price setting and incorporate the peg’s anticipated termination – i.e. higher future devaluation rates – by increasing their current prices. As tradables’ prices are determined by the law of one price, this implies higher relative non-tradables’ prices and thus a real exchange rate appreciation. Furthermore, due to intertemporal consumption substitution, the observed initial consumption boom is reproduced. Econometric evidence confirms the proposed price setting mechanism: Using the Mexican-US interest rate differential as an indicator for devaluation rate expectations, OLS regressions with monthly Mexican data find a significant positive relation between relative non-tradables’ prices and the interest rate spread during periods of pegged exchange rates. In the previous model, the stabilization effort collapses due to a fundamental inconsistency between the exchange rate target and government finance. Chapter 4 shows that the collapse can also result from self-fulfilling expectations. This is achieved by introducing partial international capital mobility. Given this constraint, both the initial consumption boom and the stabilization’s collapse can be shown to result from expectations about the duration of the peg and post-stabilization monetary policy. In conclusion, the dissertation points to the perils of ERBS in high inflation countries: Contrary to what is commonly believed, even relatively successful and long-lived exchange rate pegs are associated with a late slowdown; only very few ERBS are successful at stabilizing inflation rates in the medium and long run. The models show that stabilizations’ deficient credibility – regardless if justified by fundamentals or not – engenders real dynamics which distort economic activity and jeopardize the stabilization effort: The miracle of ERBS turns into a mirage.