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Stabilization with Exchange Rate Management under Uncertainty

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  • Allan Drazen
  • Elhanan Helpman

Abstract

Stabilization programs in open economies typically consist of two stages. In the first stage the rate of currency devaluation is reduced, but the fiscal adjustment does not eliminate the fiscal deficit which causes growth of debt and loss of reserves, making a future policy change necessary. Only later, at a second stage, is this followed by either an abandonment of exchange rate management or by a sufficiently large cut in the fiscal deficit. We study how different second-stage policy changes affect economic dynamics during the first stage. These changes include tax increases, budget cuts on traded and nontraded goods, and increases in the growth rate of money. Under certainty about the timing and nature of a switch, current account developments provide information about which policy instrument is expected to be used for stabilization. Uncertainty about the timing of a stabilization is shown to be important in explaining phenomena such as continuous reserve losses and the possibility that a policy change is accompanied by a surprise discrete devaluation rather than a run on reserves.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2268.

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Date of creation: May 1987
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Publication status: published as Economic Effects of the Government Budget, edited by Elhanan Helpman, Assaf Razin, and Efraim Sadka, pp. 310-327. Cambridge, MA: MIT Press, 1988.
Handle: RePEc:nbr:nberwo:2268

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  1. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
  2. Drazen, Allan & Helpman, Elhanan, 1987. "Stabilization with Exchange Rate Management," The Quarterly Journal of Economics, MIT Press, vol. 102(4), pages 835-55, November.
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Cited by:
  1. Guillermo A. Calvo & Allan Drazen, 1997. "Uncertain Duration of Reform: Dynamic Implications," NBER Working Papers 5925, National Bureau of Economic Research, Inc.
  2. Sergio Rebelo & Carlos A. Vegh, 1995. "Real Effects of Exchange Rate-Based Stabilization: An Analysis of Competing Theories," NBER Working Papers 5197, National Bureau of Economic Research, Inc.
  3. Gottlieb, Daniel, 1990. "Inflation and Policy Response - The Israeli Case: 1970-1989," MPRA Paper 4114, University Library of Munich, Germany.

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