Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation: “Cold Turkey” versus Gradualist Strategies

This note examines — within Bujter and Miller’s (1983) “preferred model” as well as their most general model — the costs of bringing down inflation by means of gradual reductions, of different degrees, in the growth rate of the money supply as compared to the case of a once-and-for-all cut in the rate of monetary expansion. For the dynamic simulations we employ our recently written LPF-algorithm, contained in Graziani and Almansa (1996). The results of a limited sensitivity analysis are also presented. We find that the output cost of reducing inflation, measured by the unweighted integral of the deviations of output from its potential level, is generally lower under a “cold turkey” than under any of the gradualist strategies studied. On the other hand, the economic waste of reducing inflation, approximated by the unweighted integral of the absolute deviations of output from its potential level, is generally higher under a “cold turkey” than under the gradualist strategies considered.