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Disinflation and fiscal reform: a neoclassical perspective

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  • Rigobon, Roberto

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.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 58 (2002)
Issue (Month): 2 (December)
Pages: 265-297

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Handle: RePEc:eee:inecon:v:58:y:2002:i:2:p:265-297

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Web page: http://www.elsevier.com/locate/inca/505552

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Cited by:
  1. Fernando A. Broner, 2004. "Discrete Devaluations and Multiple Equilibria in a First Generation Model of Currency Crises," 2004 Meeting Papers 264, Society for Economic Dynamics.
  2. Schmukler, Sergio L. & Serven, Luis, 2002. "Pricing currency risk under currency boards," Journal of Development Economics, Elsevier, vol. 69(2), pages 367-391, December.
  3. Sergio Rebelo & Carlos A. Vegh, 2006. "When Is It Optimal to Abandon a Fixed Exchange Rate?," NBER Working Papers 12793, National Bureau of Economic Research, Inc.
  4. Hutchison, Michael M. & Noy, Ilan, 2003. "Macroeconomic effects of IMF-sponsored programs in Latin America: output costs, program recidivism and the vicious cycle of failed stabilizations," Journal of International Money and Finance, Elsevier, vol. 22(7), pages 991-1014, December.

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