Do Exchange Rate-Based Stabilizations Carry the Seeds of Their Own Destruction?

Reinhart, Carmen and Vegh, Carlos (1999): Do Exchange Rate-Based Stabilizations Carry the Seeds of Their Own Destruction?

Abstract

Most of the major exchange rate-based stabilizations (ERRS) in chronic inflation countries in the last 30 years have ended in spectacular financial and balance of payments crises. Moreover, there is a stunning resemblance in the dynamics of the main macroeconomic variables in all these programs. In the first stages, inflation falls, the economy expands, and consumer spending (particularly of durable goods) explodes. In light of this, the figure of the Finance Minister takes God¬like proportions. Shortly thereafter, however, the “dark side” of ERRS emerges. The slow convergence of inflation fuels a large real exchange rate appreciation which, together with the fall in private saving, lead to large current account imbalances and overborrowing. At this stage, the Finance Minister faces an unenviable dilemma: deflation or devaluation. Often forced by a run on the currency, he or she is eventually left with no choice but to devalue and then, having broken the no-devaluation pledge, is forced out of office, vilified, and blamed for most of the economic ills of the country.

• Item Type: MPRA Paper
• Language: English
• Subjects: F - International Economics > F3 - International Finance > F30 - General; F - International Economics > F3 - International Finance > F32 - Current Account Adjustment ; Short-Term Capital Movements

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