INFLATION STABILIZATION AND NOMINAL ANCHORS GUILLERMO A. CALVO and CARLOS A. VEGH* This paper analyzes the choice of a nominal anchor in disinflation 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, Argentina all have succeeded in 1972). Unlike hyperinflation, 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, Peru, 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 "recession 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 money supply 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 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 36 CONTEMPORARY ECONOMIC POLICY 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 Convertibility plan, 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. Reproduced withpermission ofthe copyrightowner. Further reproduction prohibitedwithout permission. TABLE 1 Inflation, Devaluation, and Real Exchange Rate Appreciation in Selected Exchange-Rate-Based Programs Q Quarter before Last Quarter Real ~ 0 of Program Exchange Program ~ Devaluation Inflation Devaluation Inflation Rate Rate Rate Rate Appreciation Programs Perioda (4Q (4Q change) (4Q change) (4Q change) (in percent)c ::a~ge)b ~ Argentina 1967 1967.2-1970.1 85.6 26.6 0.0 8.5 25.0 Brazil 1964 1964.2-1968.2 188.0 95.4 18.6 20.7 26.6 ~ ~ Uruguay 1968 1968.3-1971.3 183.1 167.2 0.0 23.6 28.6 ~ Argentine tablita 1979.1-1980.4 67.9 167.3 23.1 88.7 46.3 ff) :;! Chilean tablita 1978.1-1982.1 60.5 66.3 0.0 7.6 28.8 Cd Uruguayan tablitad 1978.4-1982.3 28.3 41.9 15.1 25.2 48.2 ~ Austral (Argentina) 1985.3-1986.3 1,462.2 1,036.2 33.5 59.4 4.6 ~ Cruzado (Brazil) 1986.2-1986.4 211.0 263.5 42.0 76.7 9.3 ~ Israel 1985e 1985.3-1990.2 434.0 386.1 3.3 16.4 16.7 Mexico 1987e 1988.1-1992.4 139.3 148.4 1.4 13.2 36.6 ~ Convertibility (Arg/ 1991.2-1992.4 106.8 453.0 -0.8 17.8 20.2 aQuarters during which the program was in effect. If a program started late in a quarter, the following quarter is taken as the first quarter. "Four-quarter (4Q) change indicates percentage change over same quarter of previous year. <cumulative real appreciation (i.e., fall in the real exchange rate) during the program. Yearly data was used for Brazil 1964, Uruguay 1968, and i Israel 1985. dLast quarter for devaluation and inflation refers to 82.1, before the devaluation rate was increased. "Duration of program has been arbitrarily set to five years. £Program in progress; terminal date determined by data availability. I Sources: Bufman and Leiderman (1993), Di Tella (1983), Kiguel and Liviatan (1989), Machinea and Fanelli (1988), and International Financial Statistics (IMF). 'I(;) Reproduced withpermission ofthe copyrightowner. Further reproduction prohibitedwithout permission. TABLE 2 ~ Current Account and Real Interest Rates in