Devaluation Risk and the Syndrome of Exchange-Rate-Based Stabilizations

48 Pages Posted: 8 Jul 1999 Last revised: 12 Oct 2010

See all articles by Enrique G. Mendoza

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: March 1999

Abstract

This paper shows that the risk of devaluation can be an important factor accounting for the stylized facts of exchange-rate-based stabilizations. This conclusion follows from studying the quantitative implications of a two-sector equilibrium business cycle model of a small open economy calibrated to Mexico's 1987-1994 stabilization plan. In the model a time-variant interest rate differential that acts as a stochastic tax on money demand, labor supply, investment, and saving. Under incomplete markets, this tax induces endogenous state-contingent wealth effects via fiscal adjustment and suboptimal investment. Devaluation risk entails large welfare costs in this environment.

Suggested Citation

Mendoza, Enrique G. and Uribe, Martin, Devaluation Risk and the Syndrome of Exchange-Rate-Based Stabilizations (March 1999). NBER Working Paper No. w7014, Available at SSRN: https://ssrn.com/abstract=155549

Enrique G. Mendoza (Contact Author)

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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