Exchange Rate-Based Inflation Stabilization

• Author: A. Javier Hamann
• Pages: 5-6

Page 5

In the early 1990s, Kiguel and Liviatan identified several empirical regularities that arise when inflation is brought down from chronically high levels using the exchange rate as the nominal anchor.¹ The main features of this so- called ERBS "syndrome" include a boom-bust cycle in output, as opposed to the recessionary effects of MBS; a surge in consumption and investment; a pronounced real exchange rate appreciation; and worsening external accounts. Subsequently, a substantial amount of research-much of it carried out at the IMF-was devoted to further identifying the distinctive features of this syndrome and, later, to explaining it.² Some attempts at identifying whether the syndrome was also observed in low-inflation countries yielded mostly negative results.³ On the other hand, empirical evidence from transition economies supported the existence of the ERBS syndrome.⁴

More recently, the notion of an ERBS syndrome has been challenged. Santaella and Vela (1996) observe that the studies identifying the ERBS syndrome are based mostly on casual observation across episodes and that their robustness has not been assessed properly.⁵ They argue that the Mexican experience in 1987-94 is not fully consistent with the ERBS syndrome. In work done at the World Bank, Easterly (1996) finds that disinflations from chronically high levels are accompanied by an acceleration in output growth, irrespective of whether the exchange rate is the anchor.⁶ Importantly, his sample-selected on the basis of the actual behavior of inflation-includes several African stabilizations, unlike the studies that first identified the syndrome, which relied on a small set of well-documented stabilizations in Latin America and Israel. Following a methodology similar to Easterly's for identifying stabilizations, Hamann (1999) re-examines the ERBS syndrome and finds little support for it.⁷ Like Easterly, he finds no difference in the behavior of output during disinflation between ERBS and other stabilizations, although he does find evidence of a consumption boom during ERBS. In contrast, Fischer, Sahay, and Végh (2000) do find evidence that ERBS are characterized by higher output growth and a distinctive consumption/investment cycle.⁸Although they, too, use a sample selected on the basis of the behavior of actual inflation, they focus on cases where prestabilization inflation was at least 100 percent a year, compared with 40 percent in the studies by Easterly and Hamann.

Case studies conducted recently at the IMF highlight two issues that help reconcile the conflicting findings described above: (1) the role of the anchor during disinflation is not as clear-cut as portrayed in theoretical comparisons of ERBS with MBS; and (2) for output dynamics, what matters is the de facto exchange rate regime rather than the announced regime (although, admittedly, the announcement of a path for the exchange rate-especially if not fully credible-may be a key...