• 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. How have the Rates of Inflation in the UK Changed Since the Monetary Policy ...

    As explained in the theory section, changes in aggregate demand have large effects on the levels of inflation due to the monetarist transmission mechanism, as explained in diagram 2, so increased consumer confidence, and hence increased consumer spending should lead to increases in the inflation unless they are controlled by either government or the MPC depending on when they occurred.

  2. Budget 2004-05 and Economic Analysis of Pakistan

    MONETARY POLICY: The State Bank of Pakistan (SBP) continued with an easy monetary policy stance during the year with a view to reinforcing the growth momentum that had picked up last year. Accordingly, the interest rate environment not only remained investor-friendly but middle class borrower also benefited from such environment.

  1. Governments set economic objectives - Discuss the relative importance of each of these objectives ...

    Keynesians believe that inflation is caused by changes in real variables - there is excess demand in the economy. The increase in demand could have been caused by four possible factors: an increase in consumer confidence, increase in investment due to the rate of return on capital increases, increase in

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

    The government may use fiscal policy by varying the level of its expenditure and/or its tax revenue to influence the behaviour of the economy. Fiscal policy can be implemented on three distinct areas4: 1. Policies related to the purchases of goods and services by the government.

  1. 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.?

  2. This report will highlight how Government policy could change to try to: Increase economic ...

    * Higher interest rates could also be used to limit monetary inflation. A rise in real interest rates should reduce the demand for lending. See Fig 1 Figure 1 2. The introduction of Fiscal Policies to increase the rate of leakages from the circular flow and reduce injections into the

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

    Wicker found an at least 4 percentage point increase in unemployment rate and 1% decline in real GDP which were significant to monetary reform. On all accounts, the facts of the termination of hyperinflation in Austria were difficult to reconcile with the Rational Expectation Hypothesis.

  2. Various Macro-Economic Questions and answers

    A recession is a self forfilling prophicy, as soon as people think the economy is going to decline, investment stops and for that reason the economy does actually decline as without new machinery, companies become uncompetitive and demand for capital equipment falls.

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