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

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‘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) show sustained inflation rates of over 25% have routinely appeared in no less than 54 countries across the world since 1965. They also identify a small group of 14 (mainly Latin American) countries, which have persistently dogged by “chronic inflation” from 1965-89. More recent examples include Argentina and Brazil in the 1990’s. The effects of high levels can be devastating, with in almost all cases, huge corresponding falls in output, rises in unemployment and rises in government deficits as well as the obvious psychological harm and distress that it will cause the unfortunate members of the afflicted country.


Stabilisation programs:

Programs aimed to reduce these inflationary pressures are known as stabilisation programs and will typically take 3 main forms:

  • Populist approach: Aims to address a range of macroeconomic issues such as production failures, income distribution and external crisis as well as inflation. This is done through a stimulation of aggregate demand as well as the implementation of wage and price controls. Examples of this approach are Chile under Allende (1970-73) and Peru under Garcia (1986-89). Outcomes of both were high levels of inflation (exceeding 6000% in Peru in 1988) as well as extreme exchange rate overvaluation.

  • Orthodox approach: Uses a nominal anchor (either monetary growth or exchange rate targets) in order to implement the necessary fiscal adjustments needed to reduce demand. Examples of using monetary growth as a target are Chile (1973) and Bolivia (1985). It is also worth noting here that, as the central bank is not the sole source of base money (the others being the balance of payments and the private sector), fiscal contraction will not automatically imply a reduction in money growth. The so-called “Southern cone” exchange rate based approaches encompass attempts by Chile, Argentina and Uruguay in 1978. Results do vary but typically result in a gradual fall in inflation as well as a loss of output and corresponding high levels of unemployment. Exchange rate overvaluation is an additional danger of this approach.
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  • Heterodox approach: These are based on the premise of a strong inertial component in inflation and combine features of the other two approaches in the form of price controls, fiscal adjustment and a nominal anchor in the form of the exchange rate. The presence of inflationary inertia is normally brought about by the existence of backward-looking indexation mechanisms (such as monetary aggregates or the exchange rate), and will prolong the recovery period that the economy faces. As Agenor and Montiel (1996) note, when inertia is absent (the case under hyperinflation) “quick inflation convergence with minimal output costs is possible”. ...

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