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Devaluation Risk and the Syndrome of Exchange-Rate-Based Stabilizations

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  • Enrique G. Mendoza
  • Martin Uribe

Abstract

This paper shows that the risk of devaluation can be an important factor accounting for the stylized facts of exchange-rate-based stabilizations. This conclusion follows from studying the quantitative implications of a two-sector equilibrium business cycle model of a small open economy calibrated to Mexico's 1987-1994 stabilization plan. In the model a time-variant interest rate differential that acts as a stochastic tax on money demand, labor supply, investment, and saving. Under incomplete markets, this tax induces endogenous state-contingent wealth effects via fiscal adjustment and suboptimal investment. Devaluation risk entails large welfare costs in this environment.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7014.

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Date of creation: Mar 1999
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Publication status: published as Carnegie-Rochester Conference Series on Public Policy, Vol. 53 (2000),forthcoming.
Handle: RePEc:nbr:nberwo:7014

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Cited by:
  1. Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "Stabilization Policy and the Costs of Dollarization," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 33(2), pages 482-509, May.
  2. Ariel T. Burstein & Joao C. Neves & Sergio Rebelo, 2000. "Distribution Costs and Real Exchange Rate Dynamics During Exchange-Rate-Based Stabilizations," RCER Working Papers, University of Rochester - Center for Economic Research (RCER) 473, University of Rochester - Center for Economic Research (RCER).
  3. Kose, M. Ayhan, 2002. "Explaining business cycles in small open economies: 'How much do world prices matter?'," Journal of International Economics, Elsevier, Elsevier, vol. 56(2), pages 299-327, March.
  4. Stanley Fischer & Ratna Sahay & Carlos A. Vegh, 2002. "Modern Hyper- and High Inflations," NBER Working Papers 8930, National Bureau of Economic Research, Inc.
  5. Christian Fahrholz, 2003. "Strategic Exchange-Rate Policy of Accession Countries in ERM II," Eastward Enlargement of the Euro-zone Working Papers, Free University Berlin, Jean Monnet Centre of Excellence wp14, Free University Berlin, Jean Monnet Centre of Excellence, revised 01 Apr 2003.
  6. Fabio M. Natalucci & Federico Ravenna, 2002. "The road to adopting the euro: monetary policy and exchange rate regimes in EU candidate countries," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 741, Board of Governors of the Federal Reserve System (U.S.).
  7. Neven Valev & John A. Carlson, 2002. "Tenuous Financial Stability," International Center for Public Policy Working Paper Series, at AYSPS, GSU, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University paper0210, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.
  8. Enrique G. Mendoza & Martin Uribe, 1999. "The Business Cycles of Balance-of-Payment Crises: A Revision of Mundellan Framework," NBER Working Papers 7045, National Bureau of Economic Research, Inc.

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