Losing Credibility: The Stabilization Blues

International Economic Review

Posted: 23 Nov 1998

See all articles by Pablo E. Guidotti

Pablo E. Guidotti

Ministry Of Economy, Public Works and Services, Argentina

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS); University of Maryland - Department of Economics; University of California at Los Angeles; National Bureau of Economic Research (NBER)

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Abstract

The exchange rate is, by far, the most popular nominal anchor in inflation stabilization programs in developing countries. The credibility associated with exchange rate-based stabilization plans appears to exhibit a distinctive dynamic pattern. Credibility rises in the early stages of these programs as the exchange rate anchor brings about price stability with no real costs, only to fall later on as the recessionary effects of the ensuing real appreciation begin to take hold. In the late stages of such programs--which often fail--credibility seems to fall precipitously, as the question becomes not if but when the program will be abandoned.

This paper formalizes this dynamic pattern of credibility. It develops a political economy model that provides a natural definition of credibility and shows how economic and political variables influence credibility. The model assumes that the stabilization plan takes place in two stages. In the first stage, an exchange rate peg is implemented and the fiscal deficit is partially reduced. In the second stage--which may in fact never take place--the fiscal adjustment is completed. After the implementation of the plan, pressure groups negotiate over which group will bear the cost of the taxes needed to close the remaining fiscal gap (i.e., they engage in a war of attrition). At the same time, the real appreciation of the domestic currency leads to expectations of a devaluation, loss of international reserves and, potentially, to a balance of payments crisis.

In this context, credibility is defined as the conditional probability that the budget agreement takes place before a balance of payments crisis develops. The paper shows that credibility rises in the early stages of the program, as international reserves are still plenty, interest rates are low, and the public debt has yet to skyrocket. Later, however, crediblity begins to fall, as rising interest rates make it more likely that a balance of payments crisis will take place and a large public debt makes it more costly for political groups to concede. The model thus suggests that if a budget agreement is not reached in the early stages of the plan, the program may quickly lose credibility and end in a full-blown crisis due to the intrinsic dynamics of a two-stage plan.

Note: This is a description of the paper and not the actual abstract.

JEL Classification: F41

Suggested Citation

Guidotti, Pablo E. and Vegh, Carlos A., Losing Credibility: The Stabilization Blues. International Economic Review, Available at SSRN: https://ssrn.com/abstract=137596

Pablo E. Guidotti

Ministry Of Economy, Public Works and Services, Argentina ( email )

Hipolito Yrigoyen 250-5th Floor-Room 506
Buenos Aires, 1310
Argentina

Carlos A. Vegh (Contact Author)

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS) ( email )

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Washington, DC 20036-1984
United States

University of Maryland - Department of Economics ( email )

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University of California at Los Angeles ( email )

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310-825-9528 (Fax)

HOME PAGE: http://vegh.sscnet.ucla.edu

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