Exchange rate rules in support of disinflation programs in developing countries
AbstractThis paper analyzes how exchange rate policies can best support the sustainability of disinflation programs. Freezing the nominal exchange rate frequently has been recommended as a means of suppressing inertial inflation and accelerating the disinflation process. However, because any resultant real exchange rate appreciation often must be corrected through a subsequent devaluation, targeting the nominal exchange rate may merely postpone inflation rather than eliminate it once-and-for-all. This paper argues that because excessive inflation during any particular period may jeopardize the stabilization program, exchange rate policies should be designed to smooth inflation across all phases of the disinflation experience. Toward that end, an initial devaluation followed by partial indexation of the exchange rate to domestic prices may be useful. The paper then considers how inconsistencies between an exchange rate rule and balance-of-payments viability may lead to "reserves crises". Depending upon the credibility of the government's commitment to stabilization, the devaluation prompted by a reserves crisis could trigger additional inflation sufficient to cause the failure of the disinflation program. These considerations underscore the importance of policies that prevent excessive appreciation of the real exchange rate during the disinflation process.
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Bibliographic InfoPaper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 402.
Date of creation: 1991
Date of revision:
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