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Temporary Stabilization and the Real Option of Waiting when Consumption can be Delayed: an Extreme Value Approach

  • Francisco Venegas-Martínez

This paper develops, in a small open economy framework, a stochastic model of exchange-rate-based inflation stabilization that is expected to be temporary. Agents have expectations of devaluation driven by a mixed diffusion-jump process where the expected size of a possible devaluation is supposed to have an extreme value distribution of the Fréchet type; as the stylized facts from the Mexican's 1994 and Argentinean's 2001 cases have show n. Consumption and wealth equilibrium dynamics are examined when a stabilization plan is implemented. The case of a stochastic stabilization horizon guided by an exponential distribution is studied. Moreover, this paper also deals with pricing the real option of waiting for postponing consumption when a stabilization plan is about to be abandoned; a claim on a non-traded asset. We also assess the effects of exogenous shocks on consumption and economic welfare. Finally, we use the proposed model to carry out simulation experiments that reproduces the booms of private consumption in the Mexican case of 1989-1994 and the Argentinean case of 2001-2003, which resulted in extreme devaluations.

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File URL: http://degit.sam.sdu.dk/papers/degit_10/C010_043.pdf
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Paper provided by DEGIT, Dynamics, Economic Growth, and International Trade in its series DEGIT Conference Papers with number c010_043.

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Length: 28 pages
Date of creation: Jun 2005
Date of revision:
Handle: RePEc:deg:conpap:c010_043
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  1. Drazen, Allan & Helpman, Elhanan, 1987. "Stabilization with Exchange Rate Management," The Quarterly Journal of Economics, MIT Press, vol. 102(4), pages 835-55, November.
  2. Mendoza, Enrique & Uribe, Martin, 1997. "The Syndrome of Exchange-Rate-Based Stabilizations and the Uncertain Duration of Currency Pegs," Working Papers 97-30, Duke University, Department of Economics.
  3. Rebelo, Sérgio, 1995. "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," CEPR Discussion Papers 1220, C.E.P.R. Discussion Papers.
  4. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  6. Carlos A. Végh, 1992. "Stopping High Inflation: An Analytical Overview," IMF Staff Papers, Palgrave Macmillan, vol. 39(3), pages 626-695, September.
  7. Enrique G. Mendoza & Martin Uribe, 1998. "The business cycles of currency speculation: a revision of the Mundellian framework," International Finance Discussion Papers 617, Board of Governors of the Federal Reserve System (U.S.).
  8. Henderson, Vicky & Hobson, David G., 2002. "Real options with constant relative risk aversion," Journal of Economic Dynamics and Control, Elsevier, vol. 27(2), pages 329-355, December.
  9. Francisco Venegas Martínez, 2005. "Política fiscal, estabilización de precios y mercado incompletos," Estudios Económicos, El Colegio de México, Centro de Estudios Económicos, vol. 20(1), pages 3-25.
  10. Venegas Martínez, Francisco & Fundia Aizenstat, Andrés, 2006. "Opciones reales, valuación financiera de proyectos y estrategias de negocios. Aplicaciones al caso mexicano," El Trimestre Económico, Fondo de Cultura Económica, vol. 0(290), pages 363-405, abril-jun.
  11. Uribe, Martin, 1997. "Exchange-rate-based inflation stabilization: The initial real effects of credible plans," Journal of Monetary Economics, Elsevier, vol. 39(2), pages 197-221, July.
  12. Francisco Venegas-Martínez, 2000. "On Consumption, Investment and Risk," Economía Mexicana NUEVA ÉPOCA, , vol. 0(2), pages 227-244, July-Dece.
  13. Venegas-Martinez, Francisco, 2006. "Stochastic temporary stabilization: Undiversifiable devaluation and income risks," Economic Modelling, Elsevier, vol. 23(1), pages 157-173, January.
  14. Strobel, Frank, 2005. "Monetary integration and inflation preferences: A real options analysis," European Economic Review, Elsevier, vol. 49(4), pages 845-860, May.
  15. Guillermo A. Calvo & Allan Drazen, 1997. "Uncertain Duration of Reform: Dynamic Implications," NBER Working Papers 5925, National Bureau of Economic Research, Inc.
  16. Venegas-Martinez, Francisco, 2001. "Temporary stabilization: A stochastic analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 25(9), pages 1429-1449, September.
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