Stabilization Dynamics and Backward-Looking Contracts
Summary:
Exchange rate-based stabilizations often result in an initial output expansion. One explanation for this phenomenon has been that, in the presence of inflation inertia, a reduction in the nominal interest rate causes the domestic real interest rate to fall, thus increasing aggregate demand. This paper reexamines this issue in the context of an intertemporal optimizing model. In contrast to previous results, the analysis shows that, if the intertemporal elasticity of substitution is smaller than the elasticity of substitution between traded and home goods, a permanent reduction in the rate of devaluation leads to a fall in aggregate demand.
Series:
Working Paper No. 93/29
Subject:
English
Publication Date:
March 1, 1993
ISBN/ISSN:
9781451844726/1018-5941
Stock No:
WPIEA0291993
Format:
Paper
Pages:
38
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