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Exchange rate rules in support of disinflation programs in developing countries

  • Steven B. Kamin
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    This paper analyzes how exchange rate policies can best support the sustainability of disinflation programs. Freezing the nominal exchange rate frequently has been recommended as a means of suppressing inertial inflation and accelerating the disinflation process. However, because any resultant real exchange rate appreciation often must be corrected through a subsequent devaluation, targeting the nominal exchange rate may merely postpone inflation rather than eliminate it once-and-for-all. This paper argues that because excessive inflation during any particular period may jeopardize the stabilization program, exchange rate policies should be designed to smooth inflation across all phases of the disinflation experience. Toward that end, an initial devaluation followed by partial indexation of the exchange rate to domestic prices may be useful. The paper then considers how inconsistencies between an exchange rate rule and balance-of-payments viability may lead to "reserves crises". Depending upon the credibility of the government's commitment to stabilization, the devaluation prompted by a reserves crisis could trigger additional inflation sufficient to cause the failure of the disinflation program. These considerations underscore the importance of policies that prevent excessive appreciation of the real exchange rate during the disinflation process.

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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 402.

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    Date of creation: 1991
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    Handle: RePEc:fip:fedgif:402
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    1. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
    2. Giavazzi, Francesco & Pagano, Marco, 1988. "The advantage of tying one's hands : EMS discipline and Central Bank credibility," European Economic Review, Elsevier, vol. 32(5), pages 1055-1075, June.
    3. Kiguel, Miguel A & Liviatan, Nissan, 1988. "Inflationary Rigidities and Orthodox Stabilization Policies: Lessons from Latin America," World Bank Economic Review, World Bank Group, vol. 2(3), pages 273-98, September.
    4. Rudiger Dornbusch, 1988. "Notes on Credibility and Stabilization," NBER Working Papers 2790, National Bureau of Economic Research, Inc.
    5. Agenor, Pierre-Richard, 1994. "Credibility and exchange rate management in developing countries," Journal of Development Economics, Elsevier, vol. 45(1), pages 1-16, October.
    6. Dani Rodrik, 1988. "Promises, Promises: Credible Policy Reform via Signaling," NBER Working Papers 2600, National Bureau of Economic Research, Inc.
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