Credibility And The Dynamics Of Stabilization Policy

This paper studies price stabilization policy under both predetermined and flexible exchange rates. Under predetermined exchange rates, a non-credible stabilization program results in an initial expansion of output, followed by a later recession. The initial expansion accompanies an appreciating real exchange rate. Under flexible exchange rates, the recession occurs at the beginning of the program. The real exchange rate appreciates sharply on impact but depreciates afterwards. Lack of credibility is more costly under predetermined exchange rates because the real effects are more pronounced.

This paper studies price stabilization policy under both predetermined and flexible exchange rates. Under predetermined exchange rates, a non-credible stabilization program results in an initial expansion of output, followed by a later recession. The initial expansion accompanies an appreciating real exchange rate. Under flexible exchange rates, the recession occurs at the beginning of the program. The real exchange rate appreciates sharply on impact but depreciates afterwards. Lack of credibility is more costly under predetermined exchange rates because the real effects are more pronounced.

The exchange rate is, by far, the most popular nominal anchor in inflation stabilization programs in developing countries. The credibility associated with exchange rate-based stabilization plans appears to exhibit a distinctive dynamic pattern. Credibility rises in the early stages of these programs as the exchange rate anchor brings about price stability with no real costs, only to fall later on as the recessionary effects of the ensuing real appreciation begin to take hold. In the late stages of such programs--which often fail--credibility seems to fall precipitously, as the question becomes not if but when the program will be abandoned. This paper formalizes this dynamic pattern of credibility. It develops a political economy model that provides a natural definition of credibility and shows how economic and political variables influence credibility. The model assumes that the stabilization plan takes place in two stages. In the first stage, an exchange rate peg is implemented and the fiscal deficit is partially reduced. In the second stage--which may in fact never take place--the fiscal adjustment is completed. After the implementation of the plan, pressure groups negotiate over which group will bear the cost of the taxes needed to close the remaining fiscal gap (i.e., they engage in a war of attrition). At the same time, the real appreciation of the domestic currency leads to expectations of a devaluation, loss of international reserves and, potentially, to a balance of payments crisis. In this context, credibility is defined as the conditional probability that the budget agreement takes place before a balance of payments crisis develops. The paper shows that credibility rises in the early stages of the program, as international reserves are still plenty, interest rates are low, and the public debt has yet to skyrocket. Later, however, crediblity begins to fall, as rising interest rates make it more likely that a balance of payments crisis will take place and a large public debt makes it more costly for political groups to concede. The model thus suggests that if a budget agreement is not reached in the early stages of the plan, the program may quickly lose credibility and end in a full-blown crisis due to the intrinsic dynamics of a two-stage plan.

This paper examines some recent techniques designed to draw inferences about the credibility of changes in macroeconomic policy regimes. An alternative two-step approach, based on the decomposition between permanent and transitory components of a "credibility variable" is proposed. The methodology is then used to test for the existence of a credibility effect in the Cruzado stabilization plan implemented in Brazil in 1986.

In exchange rate-based stabilization programs, credibility often follows a distinct time pattern. At first it rises as the highly visible nominal anchor provides a sense of stability and hopes run high for a permanent solution to the fiscal problems. Later, as the domestic currency appreciates in real terms and the fiscal problems are not fully resolved, the credibility of the program falls, sometimes precipitously. This paper develops a political-economy model that focuses on the evolution of credibility over time, and is consistent with the pattern just described. Inflation inertia and costly budget negotiations play a key role in the model.

We study the effects of a credible, gradual exchange rate based disinflation program in a two sector economy. After an initial real exchange rate depreciation, the reductions in the rate of devaluation reduce the monetary wedge generated by a cash in advance constraint, leading to a gradual increase in absorption that yields progressive real exchange rate appreciations and current account deficits. An initial boom in economic activity is not followed by a later contraction, as labor supply expands during the whole length of the program.

This paper analyzes stabilization policy under predetermined exchange rates in a cash-in-advance, staggered-prices model. Under full credibility, a reduction in the rate of devaluation results in an immediate and permanent reduction in the inflation rate, with no effect on output or consumption. In contrast, a non-credible stabilization results in an initial expansion of output, followed by a later recession. The inflation rate of home goods remains above the rate of devaluation throughout the program, thus resulting in a sustained real exchange rate appreciation.

A minimal central bank credibility, with a non-zero probability of not renegning his commitment ("quasi-commitment"), is a necessary condition for anchoring inflation expectations and stabilizing inflation dynamics. By contrast, a complete lack of credibility, with the certainty that the policy maker will renege his commitment ("optimal discretion"), leads to the local instability of inflation dynamics. In the textbook example of the new-Keynesian Phillips curve, the response of the policy instrument to inflation gaps for optimal policy under quasi-commitment has an opposite sign than in optimal discretion, which explains this bifurcation.