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Sticky Inflation and the Real Effects of Exchange Rate Based Stabilization

  • Oya Celasun
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    Exchange rate-based inflation stabilization (ERBS) policies are associated with a boom-recession cycle in economic activity and sustained real exchange rate appreciation. A class of models in the literature has explained these empirical regularities with the lack of credibility of the stabilization plans. The lack-of-credibility models typically assume perfectly forward-looking pricing behavior without inflation stickiness and attribute the slow decline in inflation to the consumption boom that occurs due to the perceived temporariness of the ERBS policy. This paper tests the empirical validity of forward-looking pricing behavior in Mexico and Turkey, two countries which have experienced ERBS. It finds that the forward- and backward-looking components of inflation weigh approximately equally in pricing behavior, and therefore, that inflation is partially sticky. The paper then develops the theoretical implications of partial inflation stickiness in a lack of credibility model of ERBS and concludes that the presence of stickiness significantly reduces the persistence of the consumption boom predicted by the model, but helps to explain the recession in the late phase of the stabilization.

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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 03/151.

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    Length: 34
    Date of creation: 01 Jul 2003
    Date of revision:
    Handle: RePEc:imf:imfwpa:03/151
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    1. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    2. Mendoza, Enrique G. & Uribe, Martin, 2000. "Devaluation risk and the business-cycle implications of exchange-rate management," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 239-296, December.
    3. McCallum, Bennett T, 1976. "Rational Expectations and the Natural Rate Hypothesis: Some Consistent Estimates," Econometrica, Econometric Society, vol. 44(1), pages 43-52, January.
    4. Gali, Jordi & Gertler, Mark, 1999. "Inflation dynamics: A structural econometric analysis," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 195-222, October.
    5. Mankiw, N. Gregory & Reis, Ricardo, 2002. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Scholarly Articles 3415324, Harvard University Department of Economics.
    6. Dornbusch, Rudiger, 1982. "Stabilization policies in developing countries: What have we learned?," World Development, Elsevier, vol. 10(9), pages 701-708, September.
    7. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
    8. De Gregorio, Jose & Guidotti, Pablo E & Vegh, Carlos A, 1998. "Inflation Stabilisation and the Consumption of Durable Goods," Economic Journal, Royal Economic Society, vol. 108(446), pages 105-31, January.
    9. Ghezzi, Piero, 2001. "Backward-looking indexation, credibility and inflation persistence," Journal of International Economics, Elsevier, vol. 53(1), pages 127-147, February.
    10. Calvo, Guillermo A, 1986. "Temporary Stabilization: Predetermined Exchange Rates," Journal of Political Economy, University of Chicago Press, vol. 94(6), pages 1319-29, December.
    11. Rodriguez, Carlos Alfredo, 1982. "The Argentine stabilization plan of December 20th," World Development, Elsevier, vol. 10(9), pages 801-811, September.
    12. Jonathan D. Ostry & Carmen M. Reinhart, 1992. "Private Saving and Terms of Trade Shocks: Evidence from Developing Countries," IMF Staff Papers, Palgrave Macmillan, vol. 39(3), pages 495-517, September.
    13. Jorge E. Roldós, 1995. "Supply-Side Effects of Disinflation Programs," IMF Staff Papers, Palgrave Macmillan, vol. 42(1), pages 158-183, March.
    14. Drazen, Allan & Helpman, Elhanan, 1987. "Stabilization with Exchange Rate Management," The Quarterly Journal of Economics, MIT Press, vol. 102(4), pages 835-55, November.
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