Temporary Stabilization and the Real Option of Waiting when Consumption can be Delayed: an Extreme Value Approach
AbstractThis paper develops, in a small open economy framework, a stochastic model of exchange-rate-based inflation stabilization that is expected to be temporary. Agents have expectations of devaluation driven by a mixed diffusion-jump process where the expected size of a possible devaluation is supposed to have an extreme value distribution of the Fréchet type; as the stylized facts from the Mexican's 1994 and Argentinean's 2001 cases have show n. Consumption and wealth equilibrium dynamics are examined when a stabilization plan is implemented. The case of a stochastic stabilization horizon guided by an exponential distribution is studied. Moreover, this paper also deals with pricing the real option of waiting for postponing consumption when a stabilization plan is about to be abandoned; a claim on a non-traded asset. We also assess the effects of exogenous shocks on consumption and economic welfare. Finally, we use the proposed model to carry out simulation experiments that reproduces the booms of private consumption in the Mexican case of 1989-1994 and the Argentinean case of 2001-2003, which resulted in extreme devaluations.
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Bibliographic InfoPaper provided by DEGIT, Dynamics, Economic Growth, and International Trade in its series DEGIT Conference Papers with number c010_043.
Length: 28 pages
Date of creation: Jun 2005
Date of revision:
Inflation stabilization; Contingent claims; Extreme values;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-12-01 (All new papers)
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