Stabilizations, crises and the "exit" problem - A theoretical model
Exchange-rate-based stabilisations, even if successful, usually lack credibility initially. This is reflected in high (ex post) real interest rates and some degree of real exchange rate appreciation. Empirical observation suggests that wage inflation declines smoothly over time whilst interest rates are volatile. We capture this by assuming that expectations are formed adaptively in labour markets, but rationally in financial markets. The model provides insights into: the eruption of exchange rate crises after a long period of apparently successful stabilisation; the potential advantages of a heterodox approach; when to delay a stabilisation attempt; and the optimal date for ''exit'' to a floating exchange rate.
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