• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

'Less than credible stabilisation will not eliminate inertia and will generate real exchange rate overvaluation'.

Extracts from this document...

Introduction

'Less than credible stabilisation will not eliminate inertia and will generate real exchange rate overvaluation' Inflationary pressures persistently dog every type of economy across the world. However, the pressures are typically much higher amongst many developing counties. In many cases, aside from the lack of necessary economic tools required to combat inflation, a major component in the constraints faced by these countries is the issue of credibility. In this essay I will focus on the role that credibility plays within various stabilisation programs, and more specifically the effect that it has on inflationary inertia and on the real exchange rate. This will be done by looking at the different types of stabilisation programs that have been used, the causes of a lack of credibility of these programs, the steps that governments can take to increase the credibility of its schemes, and finally a conclusion will be drawn regarding the links between credibility and both inflationary inertia and exchange rate overvaluation. Firstly though, it is worth looking at the scope of the effects that inflation has across the world. While the western hemisphere is in no way immune to the threat of inflation, it is true that high levels of inflation are much more widespread amongst developing countries where, as Agenor and Montiel (1996) ...read more.

Middle

Once expectations are formed as a result of a policy announcement, there is a strong temptation on the governments to renege on the policy in order to peruse additional objectives. An example of this would be the incentive to devalue a currency in order to promote output after announcing a fixed exchange rate, the policy that the public's initial expectations were formed around. Governments often have to balance economically sound policies with politically popular ones. Unemployment levels are extremely politically sensitive, with a large rise in unemployment almost certain to cause civil unrest. As decreasing unemployment and disinflation are, by and large, the incentive in this case to renege is high - something that the public and private investors are only too aware. The sequencing of micro and macroeconomic policies is also very important, and the implementation of necessary microeconomic policies such as wage and price controls, or tax reforms, before the macroeconomic measures is essential. If the government fails to do this (as in Argentina in 1985 where wage-price controls were implemented after the announcement of a fixed exchange rate), the stabilisation process will lack credibility and inflationary inertia will still be persistent. Imperfect information: If, as in many developing countries over the years, there is a rapid change of policy makers it is very hard for the public to gauge how credible a government's commitment to disinflation is. ...read more.

Conclusion

To conclude, we have seen that many stabilisation programs, and in particular, those which entail a fixed-exchange rate as a nominal anchor often lack a high degree of credibility. In the case of, amongst others, Chile (1978), Uruguay (1978) and the continuing attempts in Brazil and Argentina these have resulted in an overvaluation of the domestic exchange rate and eventual devaluation. We have also seen that the degree of inflationary inertia faced by an economy will prolong the recovery period from high or chronic inflation. Due to the aforementioned causes of credibility, it makes intuitive sense that such inflationary episodes involving a high level of inertia such as Chile (1965-70, 1972-80 & 1982-86), Bolivia (1973-74, 1982-86) and Zaire (1976-89) as well as the above examples and many others suffered a high level of inertia as a result of the lack of credibility of the stabilisation programs. Edwards, in his study of Chile and Mexico reinforces this view and finds a direct link between the level of inertia and perceived credibility. While it is accepted that the level of credibility that a program holds is by no means the sole factor of inertia or exchange rate overvaluation, it does have a significant influence on them and should be treated with the appropriate regard by any government implementing a stabilisation program. ...read more.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our AS and A Level Macroeconomics section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related AS and A Level Macroeconomics essays

  1. What conditions are necessary for a devaluation to improve the BOP? Can a small ...

    The Dutch Disease Effect is another disadvantage of a surplus. It gets its name from the discovery of large quantities of natural gas in the 1950s in the Netherlands. Most of this natural gas was exported, leading to a large, Dutch trade surplus.

  2. Budget 2004-05 and Economic Analysis of Pakistan

    CURRENT ACCOUNT BALANCE: Sustaining a current account surplus for the third year in a row has been another major achievement of this year. The current account balance excluding official transfers remained in surplus at $1369 million or (1.4 percent of GDP)

  1. Australia's place in the global economy - "Explain the reasons for our current exchange ...

    There is a directly proportional relationship between the Current Account and the Exchange Rate that is: Current Account Surplus = Appreciation of Exchange Rate Current Account Deficit = Depreciation of Exchange Rate Australia has had a persistent current account deficit, where Australia is required to pay foreign borrowings (net income component on the balance of payments)

  2. Greece financial crisis: The main causes of this crisis are? What are ...

    So what's the problem in Greece? ? Years of unrestrained spending, cheap lending and failure to implement financial reforms left Greece badly exposed when the global economic downturn struck. This whisked away a curtain of partly fiddled statistics to reveal debt levels and deficits that exceeded limits set by the Euro zone.?

  1. Outline any two main/priority issue that concern the Australian economy & discuss the effectiveness ...

    The CAD is further worsened as a result of Australia's low rate of savings. To make of for this lack of savings, Australia borrows from overseas and utilised foreign savings to fund projects. This implies that the CAD is not so much of a problem if revenue from these developments can service the debt in the future.

  2. Examine the difficulties which confront policy makers when they attempt to formulate macroeconomic policy.

    This is direct `spending by the government. 2. Policies related to transfer payments, such as employment benefits, child benefits, social security benefits and welfare payments that the government makes to households. This is indirect government spending. The government gives out money to people, who will in turn go out and do the spending themselves.

  1. What ended hyperinflation in Germany, Austria and Hungary in the 1920s? Do the facts ...

    problems to stabilize the value of Hungary's currency and other debts as there was uncertainty in the nature of the resources that backed those debts. Hungary government ran substantial deficits between 1919 and 1924. Borrowing from the State Note Institute to finance these deficits and the increasing volume of loans

  2. Various Macro-Economic Questions and answers

    costs: Unit labour costs are defined as wage costs adjusted for the level of productivity. For example a rise in unit labour costs might be brought about by firms agreeing to pay higher wages or a fall in the level of worker productivity.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work