Exchange-Rate Based Stabilizations Case Study

Since the 1940’s a number of developing countries have witnessed chronic inflation, a period of persistent hyperinflation that could last for years. Several attempts to reduce inflation were sought and a nominal anchor was used namely, the exchange rate. Such stabilization programs were known as Exchange-Rate Based Stabilizations (ERBS). “A nominal anchor is a constraint on the value of domestic money, and in some form it is a necessary element in successful policy regimes” (Mishkin 1999). So a nominal anchor is needed to provide conditions that makes price levels uniquely determined, which in its turn is crucial for ensuring price stability. It also helps promote price stability since it tackles down inflation expectations because of its constraint
Three main causes were identified: the lack of credibility or time inconsistency theory, inflation inertia and the wealth effects.
a. Lack of Credibility
According to (Calvo 1986), who first put forth the lack of credibility theory as an explanation to ERBS failures, economic agents expect that the government is going to abandon the peg at some point in the future and resume its inflationary policies. They hence increase their consumption now versus consumption in the future given the lower opportunity cost of holding money balances during the ERBS period. This initial consumption creates an output boom and a real appreciation.
In models of uncertain duration i.e. that exhibit time inconsistency (e.g. the Mexico case), the probability of the program’s success depends on the expectations of agents in the economy about the probability of devaluation and the abandon of the peg by the government. The experiences of many countries that have adopted ERBS show that only fully credible models, that instate confidence succeed, at least initially (Mendoza 1997).

b. Inflation