On Credible Disinflation

IMF Working Papers, November 1, 1993

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Study of a credible, gradual exchange rate based disinflation program in a two sector economy.
After an initial real exchange rate depreciation, reductions in the rate of devaluation reduce the monetary wedge generated by a cash in advance constraint.
The reduction in the monetary wedge leads to a gradual increase in absorption that yields progressive real exchange rate appreciations and current account deficits.
An initial boom in economic activity is not followed by a later contraction, because labor supply expands during the whole length of the program.

Cash in advance constraint: reductions in the rate of devaluation lower the monetary wedge created by this constraint.
Exchange rate dynamics: initial real depreciation followed by progressive real appreciations as absorption increases.
Labor supply response: continuous expansion of labor supply throughout the program prevents a post-boom contraction.
Current account implications: gradual depreciations and subsequent appreciations are associated with current account deficits during the program.

Subjects: Consumption, Disinflation, Foreign exchange, Inflation, Labor, Labor supply, National accounts, Prices, Real exchange rates
Keywords: Consumption, consumption opportunity, Disinflation, disinflation experiment, disinflation program, durable goods, economic activity, effect hinge, exchange rate, gradual disinflation, Inflation, inflation country, Labor supply, nominal interest rate, Real exchange rates, stabilization program, trade liberalization effort, utility function, WP