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Monopolistic Competition, Credibility and the Output Costs of Disinflation Programs: An Analysis of Price Controls

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  • Sweder van Wijnbergen

Abstract

Brazil, Argentina and Israel all used price controls as part of disinflation programs in 1985-1986. In each case they were intended to break an "inertial" component of inflation. This paper focuses on a specific mechanism through which inflation inertia can emerge: the interaction between lack of credibility of government monetary policy announcements and the price setting behavior of forward looking firms. We show that this interaction can lead to inertia extending well beyond the price setting period; that is important since the price setting period is likely to be short in high inflation economies. We develop an open economy macromodel in which firms set prices before uncertainty about government monetary policy is resolved. Lack of credibility is then shown to lead to output losses during a disinflation program. We demonstrate the effects of price controls and show that their temporary use can be defended on welfare grounds. The paper analyzes asset price behavior during disinflation programs with and without price controls and the influence of credibility problems. We discuss nominal and real interest rates, the stock market and exchange rates. Finally we show that if past government policy has any information content about future government policy, cheating on current announcements of tight policy buys current employment gains during the price control period at the cost of higher inflation afterwards. Sustaining low inflation after the price control period thus requires restrictive monetary policy during the price control period.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2302.

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Date of creation: Jul 1987
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Handle: RePEc:nbr:nberwo:2302

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  1. Barro, Robert J, 1986. "Recent Developments in the Theory of Rules versus Discretion," Economic Journal, Royal Economic Society, vol. 96(380a), pages 23-37, Supplemen.
  2. Backus, David & Driffill, John, 1985. "Inflation and Reputation," American Economic Review, American Economic Association, vol. 75(3), pages 530-38, June.
  3. Persson, Torsten & van Wijnbergen, Sweder, 1993. "Signalling, Wage Controls and Monetary Disinflation Policy," Economic Journal, Royal Economic Society, vol. 103(416), pages 79-97, January.
  4. Svensson, Lars E O, 1986. "Sticky Goods Prices, Flexible Asset Prices, Monopolistic Competition, and Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 53(3), pages 385-405, July.
  5. Horn, Henrik & Persson, Torsten, 1988. "Exchange rate policy, wage formation and credibility," European Economic Review, Elsevier, vol. 32(8), pages 1621-1636, October.
  6. Dixit, Avinash K & Stiglitz, Joseph E, 1975. "Monopolistic Competition and Optimum Product Diversity," The Warwick Economics Research Paper Series (TWERPS) 64, University of Warwick, Department of Economics.
  7. David Kreps & Robert Wilson, 1999. "Reputation and Imperfect Information," Levine's Working Paper Archive 238, David K. Levine.
  8. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  9. Svensson, Lars E. O., 1985. "Currency prices, terms of trade, and interest rates: A general equilibrium asset-pricing cash-in-advance approach," Journal of International Economics, Elsevier, vol. 18(1-2), pages 17-41, February.
  10. Joshua Aizenman, 1989. "Monopolistic Competition, Relative Prices and Output Adjustment in the Open Economy," NBER Working Papers 1787, National Bureau of Economic Research, Inc.
  11. Helpman, Elhanan & Razin, Assaf, 1984. "The role of saving and investment in exchange rate determination under alternative monetary mechanisms," Journal of Monetary Economics, Elsevier, vol. 13(3), pages 307-325, May.
  12. Barro, Robert J., 1986. "Reputation in a model of monetary policy with incomplete information," Journal of Monetary Economics, Elsevier, vol. 17(1), pages 3-20, January.
  13. Frenkel, Jacob A & Razin, Assaf, 1985. "Government Spending, Debt, and International Economic Interdependence," Economic Journal, Royal Economic Society, vol. 95(379), pages 619-36, September.
  14. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  15. Backus, David & Driffill, John, 1985. "Rational Expectations and Policy Credibility Following a Change in Regime," Review of Economic Studies, Wiley Blackwell, vol. 52(2), pages 211-21, April.
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Cited by:
  1. 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.
  2. Roberto Rigobon, 2002. "Disinflation and Fiscal Reform: A Neoclassical Perspective," NBER Working Papers 8706, National Bureau of Economic Research, Inc.
  3. Reyna-Cerecero, Mario & Mavrotas, George, 2003. "Inflation, Output and Perfectly Enforceable Price Controls in Orthodox and Heterodox Stabilization Programmes," Working Paper Series UNU-WIDER Research Paper , World Institute for Development Economic Research (UNU-WIDER).

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