erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

The Self-Fulfilling Temporariness of Exchange Rate Based Stabilizations

Bettina Krois (Humboldt-University at Berlin, Germany)

Abstract

This paper investigates the connection between the initial consumption boom during exchange rate based stabilizations and transitory nature of many of these programs. It is shown that both features can result from self-fulfilling expectations about the peg’s duration: Credible pegs achieve a permanent reduction of devaluation rate without any real effects. In contrast, stabilizations judged to be incredible effect an increase in consumption and current account deficits which ultimately compel the peg’s demise. Thus, ex ante exogenous and arbitrary expectations about the program’s duration prove to be self-fulfilling.

The analysis is carried out in terms of a one-good, cash-in-advance model with optimizing consumer-producers. The only deviation from perfect markets is the assumption of partial international capital mobility: Based on empirical evidence for developing economies (for example Williamson, 1993), the country’s maximum net foreign indebtedness is given is given as a constant fraction of period income. Results are extended to account for multiple stabilization efforts and variations in the post-stabilization devaluation rate. The magnitude of the consumption boom is shown to be positively correlated with the latter, result being consistent with empirical evidence on inflation stabilization episodes in chronic inflation countries.

Economic Research Center
Middle East Technical University
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