Arana, Alejandro Rodriguez
(1998)
Credibility and business cycles in exchange rate based stabilization programmes.
PhD thesis, London School of Economics and Political Science.
Abstract
Differently from orthodox stabilization programmes, exchange rate based stabilization programmes (ERBS) show a peculiar cycle. Output, growth and consumption rise from the onset and there is a huge current account deficit. Since several programmes have been accompanied by huge capital inflows, the economic cycle is known as the capital inflows problem. The economic literature has identified the capital inflows problem with a situation where there is not fiscal adjustment or people do not believe in the programme (see chapter two). However, chapter one of this thesis shows that the cycle has been observed in successful and consistent programmes (Argentina 1991- , Bolivia 1985- , Israel 1985- and Mexico 1987-1994). It has been also observed in absence of capital inflows (Mexico 1988). Furthermore, some of its negatives consequences (eg balance of payments crises) have occurred in programmes under fiscal adjustment. These observations deserve an explanation. Chapter two makes a review of the literature about the economic effects of ERBS. Chapter three questions why successful ERBS have observed, increases in long run growth and/or output from the onset and also the symptoms of the capital inflows problem (higher consumption, current account deficits). To answer the question, the chapter sets a growth model in a cash in advance economy. The main results are that sluggish disinflation can increase the long run growth and definitely increases the long run output of the economy. However, it cannot explain the symptoms of the capital inflows problem by itself. When the model is extended to capture some externalities, then it suggests that the structural policies accompanying successful ERBS are responsible of higher consumption and current account deficits. In those cases, that situation is not a problem. Chapter four questions why the symptoms of the capital inflows problem may appear in absence of capital inflows. The answer is that these symptoms emerge when there is lack of credibility and the monetary policy is accommodative. In this context, actual fiscal policy is irrelevant to combat the problem if it cannot change expectations of future inflation. Monetary policy is effective but often produces huge fiscal costs since real interest rates have to rise considerably. When the actual fiscal deficit increases the future expected inflation, tight monetary policy may generate a perverse effect fuelling the symptoms of the problem. Chapter five questions why ERBS that apparently are consistent may be subject to the capital inflows problem and eventually to balance of payments crises. Political factors are responsible of this situation. The chapter sets a model that resembles the Mexican political system. Actual government chooses its successor. The former has incentives to choose a future candidate with preferences for high inflation. People, forecasting this possibility, consumes more in periods of low inflation. That generates the capital inflows problem. Chapter six concludes.
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