The Analytics of Credible Exchange-Rate-Based Disinflation When Money Facilitates Firms' Transactions

Abstract:     
This paper makes three contributions to the supply-side theory of the real effects of exchange-rate-based disinflation: First, the empirical relevance of the supply-side hypothesis has been questioned on the grounds of its reliance on the assumption that purchases of investment goods are subject to a cash-in-advance constraint. This paper replaces this assumption with a more realistic one that assigns money the role of facilitating firms' transactions (such as sales and payments to factor inputs). A formal correspondence is shown to exist between the model proposed in this paper and the one in which investment is a cash good. Second, the implications of the supply-side hypothesis are derived under much weaker restrictions on preferences, technologies, and initial conditions than in existing studies. Third, equilibrium dynamics are characterized without resorting to linear approximation techniques, which are invalid in the context of the theoretical framework used in the literature on exchange-rate-based stabilization, namely, small open economy models with a constant subjective rate of discount and an exogenous world real interest rate.

JEL Classifications: E31, F31

Working Paper Series