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Stabilization Dynamics and Backward-Looking Contracts

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  • Mr. Carlos A. Végh Gramont
  • Mr. Guillermo Calvo

Abstract

Exchange rate-based stabilizations often result in an initial output expansion. One explanation for this phenomenon has been that, in the presence of inflation inertia, a reduction in the nominal interest rate causes the domestic real interest rate to fall, thus increasing aggregate demand. This paper reexamines this issue in the context of an intertemporal optimizing model. In contrast to previous results, the analysis shows that, if the intertemporal elasticity of substitution is smaller than the elasticity of substitution between traded and home goods, a permanent reduction in the rate of devaluation leads to a fall in aggregate demand.

Suggested Citation

  • Mr. Carlos A. Végh Gramont & Mr. Guillermo Calvo, 1993. "Stabilization Dynamics and Backward-Looking Contracts," IMF Working Papers 1993/029, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:1993/029
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    References listed on IDEAS

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    1. 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.
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    7. Calvo, Guillermo & Vegh, Carlos, 1991. "Exchange rate stabilization under imperfect credibility," MPRA Paper 20486, University Library of Munich, Germany.
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