STABILIZATION AND NOMINAL ANCHORS

GUILLERMO A. CALVO and CARLOS A. VEGH*

This paper analyzes the choice of a nominal anchor in programs in chronic inflation countries. Both theory and evidence suggest several conclusions. (i) The recessionary effects associated with disinflation appear in the early stages ofmoney­ based programs but only in the late stages of exchange rate-based programs. (ii) Lack of credibility is more disruptive under fixed exchange rates than under floating ex­ change rates. (iii) Attempting to pursue a disinflationary policy while maintaining a given level of the real exchange rate is likely to be self-defeating. (iv) A high degree of currency substitution favors the exchange rate as the nominal anchor.

I. INTRODUCTION Repeated attempts to get rid of the Since the late 1940s, many developing scourge of chronic inflation often have met countries have suffered from chronic infla­ with only temporary success, and inflation tion. Chronic inflation is characterized by has come back with a vengeance. How­ high inflation relative to industrial coun­ ever, Chile, Israel, Mexico, and, more re­ tries and by persistent inflation (Pazos, cently, all have succeeded in 1972). Unlike , which lasts bringing inflation below 15 percent per only months and is explosive, chronic in­ year. More often than not, the failure of flation may last several decades and is rel­ stabilization plans reflects the absence of atively stable. Harberger (1981) defines a lasting fiscal adjustment. However, even chronic inflation as annual inflation of 20 fiscally sound programs-for instance, the percent or more for at least five consecu­ Chilean and Uruguayan programs of the tive years. By this definition, countries late 1970s-have faced unsurmountable such as Argentina, Brazil, Chile, Israel, hurdles. Mexico, , and Uruguay have experi­ The Southern-Cone programs of the enced long periods of chronic inflation. late 1970s in Argentina, Chile, and Uru­ guay were characterized by an initial boom that made reducing the inflation *Senior Advisor and Economist, respectively, rate of home goods particularly difficult. Research Department, International Monetary The recessionary effects that according to Fund (IMF). This is a revised version of a paper presented at the Western Economic Association In­ conventional wisdom should follow from ternational 67th Annual Conference, San Fran­ inflation stabilizatipn came later in the cisco, Calif., July 9-13, 1992, in a session organized program. The Southern-Cone programs by John Welch of the Federal Reserve Bank of Dal­ las. The authors are grateful to Jos~ Fajgenbaum, thus gave rise to the intriguing idea-cap­ Carlos Medeiros, Gerald O'Driscoll, Jr., Ratna tured by the expression " now Sahay, Pierre Siklos, Peter Wickham, conference participants, and two anonymous referees for versus recession later" -that the choice helpful comments. A previous version of this between using the or the paper was issued as IMF working paper PPAA exchange rate as the nominal anchor may 92/ 4. Besides being published here, the paper is scheduled to appear in late Spring 1994 in an IMF involve choosing the timing of the reces­ conference volume Exchange Rate Poficy: Strategic sion. Under money-based stabilization, Choices. The views expressed here are those of the authors and do not necessarily represent those of the output costs would be paid up front the IMF. (recession now). Under an exchange-rate-

35 Contemporary Economic Policy Vol. XII, April 1994 ©Western Economic Association International

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based stabilization, the costs would be (ii) Real appreciation of the domestic cur­ paid later (recession later). rency. Given the slow convergence of in­ The experience of the Southern-Cone flation, the cumulative real appreciation of programs also led some observers to argue the domestic currency has been substan­ that a single nominal anchor might not be tial (table 1). enough to ensure a quick disinflation as (iii) Deterioration of the trade balance and problems of credibility, backward-index­ the current account. Table 2 shows that the ation, and non-synchronized price setting current account normally worsens during would generate inflation persistence (see, the programs. A similar pattern holds for for instance, Edwards and Edwards, 1991). the trade balance (Vegh, 1992).1 Large These considerations prompted the intro­ trade account imbalances, fueled by im­ duction of additional nominal anchors­ ports of durable goods, usually are behind most notably incomes policies-in the the current account deficits. programs of the mid-1980s in Argentina, (iv) Initial increase in real activity-i.e., Brazil, Israel, and Mexico. real private consumption and real GDP-fol­ This paper examines the role of nomi­ lowed by a later contraction. Table 3 shows nal anchors in inflation stabilization pro­ the growth of private consumption before grams in chronic inflation countries. Sec­ and after stabilization. Real GDP figures tion II reviews the stylized facts. Section follow a similar pattern (Vegh, 1992). In III interprets the evidence in terms of an Israel, the late slowdown occurred despite analytical framework. Section IV analyzes the program's success. The Mexican pro­ the use of multiple anchors. Section V gram has proved to be an exception in that draws policy conclusions. no late recession has occurred. The boom­ recession cycle usually is more pro­ II. STYLIZED FACTS OF INFLATION nounced for durable goods consumption, STABILIZATION as the Israeli stabilization illustrates (see This section reviews the main empirical table 3). regularities associated with inflation stabi­ (v) Ambiguous response of domestic real in­ lization in chronic inflation countries. terest rates. Ex-post domestic real interest rates fell in the early stages of the "tablitas" A. Exchange-Rate-Based Stabilization and the , although in Consider the following 11 major pro­ Chile they still remained extremely high. grams in Latin America and Israel: (i) the However, they appear to have increased heterodox programs of the 1960s in Argen­ substantially in the early stages of the het­ tina, Brazil, and Uruguay, (ii) the orthodox erodox programs of the mid-1980s (table 2). programs of the late 1970s (the so-called "tablitas") in Argentina, Chile, and Uru­ B. Money-Based Stabilization guay, (iii) the heterodox programs of the Consider five major programs: the 1975 mid-1980s in Argentina, Brazil, Israel, and Chilean plan, the 1989 Bonex plan in Ar­ Mexico, and (iv) the 1991 Convertibility gentina, and the 1990 programs in Brazil plan in Argentina. (See Kiguel and (Collar plan), Peru, and the Dominican Re- Liviatan, 1992a; Vegh, 1992). Several char­ acteristics distinguish these programs. (i) Slow convergence of inflation to the rate 1. The improvement in the current account in Is­ of devaluation. Table 1 illustrates inflation rael is related mainly to the fall in investment and persistence by showing that the (four­ the rise in unilateral transfers (see Bufman and Leiderman, 1993). However, a trade deficit averaging quarter) inflation rate has remained above 7.1 percent of GDP existed during the five years fol­ the (four-quarter) devaluation rate. lowing the program.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. (;) 'I ~ ~ 0 Q ~ ~ ~ ~ ~ ~ ~ Cd :;! ~ ff) I i and Financial 1968, 4.6 9.3 quarter. Real Rate 28.6 25.0 28.8 26.6 48.2 46.3 20.2 16.7 36.6 percent)c Exchange first (in Appreciation Uruguay the Programs International as 1964, and taken 7.6 8.5 Brazil is 25.2 23.6 20.7 76.7 59.4 88.7 13.2 16.4 17.8 change) Rate (1988), Inflation for (4Q quarter used Quarter Fanelli Program was and of Exchange-Rate-Based Last following 0.0 0.0 0.0 1.4 3.3 data 42.0 23.1 15.1 33.5 18.6 -0.8 change) Rate increased. the year. (4Q Devaluation Yearly Machinea was Selected in quarter, rate a (1989), previous in program. of 1 26.6 95.4 66.3 41.9 the late 263.5 change) 167.2 386.1 453.0 148.4 167.3 Rate 1,036.2 Liviatan Inflation devaluation (4Q quarter during started Appreciation the and TABLE before same rate) Rate Program before Kiguel availability. program over Quarter a 60.5 85.6 28.3 67.9 years. 82.1, 211.0 183.1 188.0 434.0 139.3 106.8 data If ::a~ge)b 1,462.2 exchange to (1983), five by change Devaluation (4Q to Exchange real effect. Tella refers set in the Di Real in was percentage determined fall inflation and (1993), arbitrarily date (i.e., and Perioda program indicates been 1967.2-1970.1 1985.3-1986.3 1978.4-1982.3 1986.2-1986.4 1968.3-1971.3 1979.1-1980.4 1964.2-1968.2 1978.1-1982.1 1988.1-1992.4 1991.2-1992.4 1985.3-1990.2 the has terminal Leiderman change Devaluation, which devaluation appreciation and (4Q) for (Arg/ program real progress; tablitad of during in 1967 tablita Bufman 1968 (Brazil) tablita (Argentina) Inflation, (IMF). quarter 1987e 1964 1985e 1985. Sources:

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ~ z >< ...... r' ~ ~ ~ ~ 0 0 () () m n () I (1989), Dashes Four 5.9 2.0 -- -- 4.0 13.7 24.9 11.0 46.4 -7.5 -9.5 48.1 58.0 Quarters quarters. Last Liviatan available. three and not year) Ratesb first are per to I

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. \0 (;J ~ ~ ~ ~ ~ Cj ~ ~ ~ ~ ~ ~ ~ 0 Ul i ; Viana 4.4 5.3 4.9 10.2 -9.1 17.1 Fifth quarters program -12.1 the two (1993), estimates. after staff 9.6 4.1 0.0 7.5 5.0 Year Year -0.2 program, 10.1 -9.7 year Medeiros Fourth -13.3 -12.8 Fund the one and to (1992), before up 6.4 6.8 4.3 2.4 1.0 4.3 5.7 5.8 Year -3.6 -1.1 16.0 Lustig Third sources, data quarter the (1989), Programs include national in 0.7 6.4 4.0 6.3 0.7 5.0 5.6 7.5 0.3 6.7 9.0 3.9 -0.9 13.2 10.8 10.8 Second Liviatan growth reported percent) of and in Mediterranea, Stabilization rate Figures 3 2.6 7.5 6.5 7.9 6.4 9.0 3.3 8.2 6.7 1.8 Kiguel apply. Year Year First 14.4 49.7 14.8 -1.8 -2.5 -11.4 -12.9 -15.3 not consumption. effect. growth, Fundacion Selected do (1993), in TABLE of four-quarter in be Years public) data the tables, to 0.5 6.8 0.2 0.6 3.6 before. 2.8 1.0 1.2 0.3 rate 1.5 -4.2 -6.2 -2.1 -6.3 -1.2 -0.5 -0.3 to Bension before years. and Program (average) Three Bank years taken five and indicate refer to (annual two (private was consumption. and World a to set Consumption Favaro Dashes total GDP, to 1986 1990 1986 1990 (IMF), quarters. private Period program (1993), real 1964-1968 1967-1970 1979-1982 1969-1971 1979-1981 1978-1982 1986-1990 1988-1992 1991-1992 1990-1992 1990-1992 1975-1977 Private arbitrarily four the available. corresponds Statistics not been every which corresponds quarterly are )e,f has Leiderrnan non-durables) to program then 1990f,g year data Financial and during (Arg. the totald durables and and tablita Rep. program b progress. 1967 tablita second 1968 (Brazil) years of in before tablita (Argentina) indicate 1987c correspond Bufman (Brazil) (Argentina) for Rate-Based 1964 1985c 1975 (durables 1990f,g program, Dots International the Average Calendar Programs Argentina Brazil Uruguay Uruguayan Argentine Chilean Austral Mexico Israel Convertibility Cruzado Chile Sources: Bonex Dominican Peru Collor £Program gFigures b

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public (see Edwards and Edwards, 1991; sumers must use money to purchase Kiguel and Liviatan 1992b; and Medeiros, goods-technically, they face a cash-in-ad­ 1993).2 These programs shared certain vance constraint-which implies that the characteristics. However, given the small opportunity cost of holding money (i.e., number of money-based programs in the nominal interest rate) affects the cost chronic inflation countries, one should of consumption (i.e., the effective price of view these stylized facts only as sugges­ consumption). Hence, a fall in the nominal tive. interest rate reduces the effective price of consumption by lowering the opportunity (i) Slow convergence of inflation to the rate cost of holding money. of monetary growth. Inflation persistence On the supply side, assume that the also has been present in some money­ supply of traded goods is fixed, while the based programs, although inflation seems supply of home goods is demand-deter­ to converge quicker than in exchange-rate­ mined. Firms producing the home goods based programs (table 4). set prices in a staggered way taking into (ii) Real appreciation of the domestic cur­ account the expected path of aggregate de­ rency. The real exchange rate appreciated mand and the aggregate price level. This in all five programs-often substantially non-synchronization in price-setting im­ (table 4). plies that the aggregate price level is fixed (iii) No clear-cut response in the trade bal­ at each point in time. However, the infla­ ance and the current account. The ambigu­ tion rate is free to adjust instantaneously. ous response of the current account shown (For a formal development of the model, in table 2 also holds for the trade balance. see Calvo and Vegh, 1990, 1993.) If anything, a closer look at the figures suggests a short-run improvement in the external accounts. A. Exchange-Rate-Based Stabilization (iv) Initial contraction in economic activ­ Suppose that policymakers announce a ity. As table 3 suggests, money-based sta­ reduction in the rate of devaluation. If the bilization appears to cause a sharp, announcement is fully credible-in the though short-lived, contraction in eco­ sense that the public believes that the re­ nomic activity at the beginning of the pro­ duction in the devaluation rate will be per­ grams. manent-inflation falls immediately to its (v) Initial increase in domestic real interest new equilibrium value, given by the lower rates. The liquidity "crunch" associated with rate of devaluation. Furthermore, there are a money-based stabilization typically re­ no real costs associated with eliminating sults in sharp increases in real interest rates inflation at one fell swoop. (This exercise (table 2). might be useful in interpreting the end of . See Vegh, 1992.) Ill. A BASIC ANALYTICAL FRAMEWORK Given a history of failed stabilizations, Consider a small open economy where however, the assumption of full credibility perfect capital mobility prevails. On the is unlikely to hold in chronic inflation demand side, the public consumes traded countries. Suppose, therefore, that the an­ and non-traded (or home) goods. Con- nouncement is not credible, in the sense that the public expects the higher rate of devaluation to resume at some point in the future. Viewing the fall in the nominal in­ 2. In the Dominican Republic plan, dual exchange terest rate (due to perfect capital mobility) rates were in place for a year before being unified into a single floating rate (see Medeiros, 1993). Under dual as temporary reduces the cost of present rates, however, money is still the nominal anchor. consumption relative to future consump-

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. e ~ f;2 0 ~ ~ ~ ~ ~ o:J ~ ~ ~ ~ ~ (Jl I i 9.0 9.7 quarter. Real Rate 41.8 51.2 25.5 percent)c estimates. Exchange first (in Appreciation the staff as Fund taken 6.2 and is 66.3 86.9 change) Rate 1,629.1 1,476.6 Inflation (4Q rate. quarter sources, Quarter Program of Last national exchange Appreciation following 16.9 73.7 change) 113.0 the Money Growth 2,382.7 1,070.5 Rate year. parallel (4Q Economia, quarter, de using Programs a previous in program. Exchange of 40.8 the late 363.6 change) Rate Brasileiro 2,085.6 6,232.4 4,144.8 computed Real Inflation (4Q quarter during before was started TABLE4 and Money-Based lnstituto same rate) Program availability. program over Quarter (IMF), a 40.2 Growth, Selected 234.6 appreciation data If change)b exchange 6,791.5 4,096.2 1,823.6 Money Growth in by change Real (4Q real Statistics effect. Money in the in was percentage determined Financial fall 90.03-90.12. is date Inflation, (i.e., Perioda program indicates 1990.1-1990.4 1975.2-1977.4 1990.2-1990.4 1990.3-1992.2 1990.3-1992.4 period the terminal International change which appreciation 1990e program (1985), (4Q) real progress; during data; in Rep. Corbo (Brazil)d (Argentina) 1975 1990e Sources: bFour-quarter

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tion. The ensuing increase in aggregate de­ cession that reduces the demand for real mand leads to an output expansion and a money balances.3 This recession is brought trade deficit. The overheated economy about by higher real interest rates (which keeps inflation above the rate of devalua­ reduce today's demand for home goods tion and results in a sustained real appre­ relative to tomorrow's) and a real ex­ ciation. Over time, the real appreciation change rate appreciation (which decreases reduces excess aggregate demand for the demand for home goods relative to home goods, causing output to decline. traded goods). Eventually, the economy falls into a reces­ If the announcement is not credible, the sion. picture remains basically unchanged from The model thus is able to rationalize a qualitative viewpoint. With an exoge­ most of the empirical regularities de­ nous money supply and sticky prices, the scribed in section II. (See Reinhart and results are driven mainly by the fact that Vegh, 1992, for a quantitative analysis.) the real money supply cannot change at Furthermore, the boom-recession cycle oc­ the time the plan is implemented. (The curs independently of whether the pro­ only difference is that the current account, gram eventually is abandoned-as the which remains in balance in the full-cred­ public expected-or not. Hence, the model ibility case, goes into deficit as consump­ also may explain occurring in tion of traded goods increases in anticipa­ successful programs, such as the Israeli tion of the future policy reversal.) Quanti­ one. Domestic real interest rates fall in the tatively, however, credibility plays a cru­ model, a result consistent with the evi­ cial role. The less credible the program, the dence on orthodox programs. One may ex­ smaller the initial fall in inflation. How­ plain the high real interest rates observed ever, lack of credibility also mitigates the in the heterodox programs by the use of initial recession. The reason is that the additional nominal anchors (see below). nominal interest rate does not fall by much because it is not "anchored" exogenously C. Money-Based Stabilization at a lower level as in an exchange-rate­ based stabilization. This result implies Suppose that policymakers announce a that real money demand increases very lit­ reduction in the growth rate of the money tle. Hence, lack of credibility is not costly supply. (The results that follow require in that lower benefits go hand in hand that real money demand be interest-rate with lower costs. elastic, which is not essential for the re­ In sum, the model's predictions for a sults of exchange-rate-based stabiliza­ money-based stabilization are consistent tion.) If the announcement is credible (that with the stylized facts discussed above: is, the lower rate of money growth is ex­ the initial fall in inflation is accompanied pected to be permanent), the long-run de­ by a recession, real appreciation, and high mand for real money balances increases. real interest rates. Under non-credible pol­ Hence, inflation must fall below the rate icy, the model predicts a current account of monetary growth in order to generate higher real money balances over time. The initial fall in inflation reduces the nominal interest rate, which in turn increases real 3. In theory, this initial recession could be avoided money demand. Since the real money sup­ simply by engineering an initial once-and-for-all in­ crease in the level of the nominal money supply while ply is given on impact (recall that the price at the same time reducing the rate of change of the level is sticky), there is an excess demand money supply. However, the public likely would in­ terpret such action as a lack of commitment to a tight for real money balances. Money market , which would severely undermine the equilibrium can be restored only by a re- program's credibility.

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deficit. However, the evidence suggests many programs. It may result from, that the current account's response is not among other factors, lack of credibility (as clear-cut. in the model discussed above) or wide­ spread backward indexation (Pazos, 1972). IV. MULTIPLE ANCHORS Analysts who advocate price and wage controls usually believe that these mea­ A. Tight Monetary and Credit Policy sures would help fight inflation inertia. It Too much liquidity in the initial stages also has been argued that imposing price of an exchange-rate-based program may controls may contribute to increasing the prove dangerous. Excess liquidity pro­ program's credibility. However, the short­ vides the means to finance the initial con­ run benefits of price and wage controls sumption binge, thus contributing to an may be more than offset by the resulting initial real exchange rate appreciation. distortion of relative prices and by prob­ Therefore, policymakers frequently have lems related to the timing of their removal. attempted to check the forces that too Removing controls too early may unleash much liquidity unleashes by introducing the same credibility or inertial problems additional anchors. The Israeli 1985 plan, that the controls intended to address in the for example, included an explicit target for first place. Too late a removal may result bank credit, which was to be implemented in highly distorted relative prices with the by higher reserve requirements, a higher ensuing real costs. discount rate, and a tightening of existing More fundamentally, though, the use of controls on short-term capital flows incomes policies does not seem to alter the (Barkai, 1990). The ensuing liquidity outcome of an exchange-rate-based stabi­ "crunch" provoked a sharp initial increase lization. Both orthodox and heterodox in real interest rates (table 2), which may plans have shared similar characteristics explain the initial (albeit brief) downturn (see section II). This suggests that price in economic activity that preceded the and wage controls cannot solve the under­ consumption boom. (Analytically, Calvo lying fundamental problems related to and Vegh, 1993, show that using money lack of credibility. Rather than resorting to as an additional nominal anchor results in price controls, the best hope probably is high real interest rates, real exchange rate switching from backward- to forward­ appreciation, and an initial recession.) looking indexation-that is, adjusting Sterilized intervention is a popular wages at the beginning of the program ac­ method of insulating the domestic money cording to expected inflation. stock from the expansionary effects of cap­ ital inflows at a program's beginning. V. POLICY CONCLUSIONS Even if sterilized intervention does tempo­ The preceding analysis suggests the fol­ rarily control the money supply, it may lowing policy conclusions: impose a severe fiscal burden, as the gov­ (i) Both theory and evidence indicate ernment is forced to pay higher interest that the choice of a nominal anchor-Le., rates on the public debt than it receives on the exchange rate or a monetary aggre­ the world market for its reserves (see gate-is a key policy decision. In particu­ Calvo et al., 1993). lar, although a recession seems unavoid­ able under imperfect credibility, the timing B. Price and Wage Controls of the downturn appears to depend criti­ Inflation inertia-the inflation of home cally on the choice of the nominal anchor. goods' remaining above the growth rate of (ii) Lack of credibility may be more dis­ the nominal anchor-has characterized ruptive under fixed exchange rates than

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under floating exchange rates. In a money­ real appreciation also proved helpful in based stabilization, lower credibility re­ the cases of Israel and Mexico. duces the benefits-Le., inflation falls by (iv) It should be stressed that the dy­ less-but the real effects tend to vanish as namics associated with disinflationary well. Under exchange-rate-based stabiliza­ policy discussed in this paper are unre­ tion, lower credibility also reduces the lated to fiscal problems. This is particu­ benefits (inflation may even increase). larly worrisome because it illustrates sta­ However, in contrast to money-based sta­ bilization programs' vulnerability with re­ bilization, the real disruptions are magni­ spect to the private sector's beliefs about fied. Hence, if the public is highly skepti­ a programs' economic or political sus­ cal, a money-based strategy might be less tainability. Therefore, a serious fiscal ad­ risky. On the other hand, if credibility is justment may not be enough to ensure a high (because, for example, a new admin­ program's success if for some reason the istration is taking over), the exchange rate public believes that policymakers eventu­ probably should be favored as a nominal ally will abandon the plan. Therefore, pol­ anchor, as it allows for quicker adjustment icymakers must be able to convince the of real money balances. public that the policy will be sustained (iii) Attempting to pursue a disinfla­ over time. tionary policy while maintaining a given (v) Currency substitution, a widespread level of the real exchange rate is likely to phenomenon in chronic inflation countries, be self-defeating. Both theory and evi­ appears to tilt the balance in favor of the dence suggest that real appreciation is an exchange rate as the nominal anchor (Calvo unavoidable byproduct of lowering infla­ and vegh, 1992). If the elasticity of substitu­ tion. Moreover, the public's perception tion between foreign and domestic currency that the authorities may be pursuing both is very high-which is bound to be the case objectives at the same time is bound to un­ after many years of high inflation-then dermine credibility further. The experi­ under flexible exchange rates the system ence of Israel and Mexico suggests that in may be left without a nominal anchor. Oth­ exchange-rate-based programs adjust­ erwise, floating rates do provide a nominal ments in the nominal exchange rate-i.e., anchor to the system. However, currency devaluations or changes in the rate of de­ substitution may make the initial liquidity valuation-aimed at correcting the real "crunch" and the ensuing recession more appreciation should be postponed, if pos­ severe, as the public attempts to switch from sible, until the public perceives that the foreign to domestic currency. Hence, other authorities have the fundamentals well things being equal, currency substitution under control. Initial large devaluations appears to render the exchange rate more aimed at making room for the inevitable attractive as the nominal anchor.

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