Optimal Stabilization Policies For Less Developed Economies With Rational Expectations

This paper investigates the optimal deflationary strategy for a ‘financially repressed’, less developed economy. In accordance with recent theoretical work, it is assumed that inflationary expectations are rational, although the assumption of adaptive expectations would yield qualitatively similar results. The optimizing time-paths of the two policy instruments, the rate of monetary expansion and the average nominal interest rate paid on money holdings, are explicitly derived and qualitatively characterized. We demonstrate that suitable manipulation of these instruments not only generates a smooth decline of the inflation rate to its target value, but also ensures that real output transitionally either increases or temporarily is constant, but never declines.