Carlos A. Végh

Exchange-rate-based stabilization under imperfect credibility

This paper analyzes stabilization policy under predetermined exchange rates in a cash-in-advance, staggered-prices model. Under full credibility, a reduction in the rate of devaluation results in an immediate and permanent reduction in the inflation rate, with no effect on output or consumption. In contrast, a non-credible stabilization results in an initial expansion of output, followed by a later recession. The inflation rate of home goods remains above the rate of devaluation throughout the program, thus resulting in a sustained real exchange rate appreciation.

Targeting the real exchange rate: Theory and evidence

This paper presents a theoretical and empirical analysis of policies aimed at setting a more depreciated level of the real exchange rate. An intertemporal optimizing model suggests that, in the absence of changes in fiscal policy, a more depreciated level of the real exchange can only be attained temporarily. This can be achieved by means of higher inflation and/or higher real interest rates, depending on the degree of capital mobility. Evidence for Brazil, Chile, and Colombia supports the model`s prediction that undervalued real exchange rates are associated with higher inflation.

Nominal interest rates, consumption booms, and lack of credibility: A quantitative examination

Abstract Exchange rate-based stabilization programs in chronic-inflation countries have often been accompanied by an initial expansion of private consumption followed by a contraction. This consumption cycle has been attributed to lack of credibility, in the sense that the public views the reduction in the devaluation rate as temporary. This paper assesses the quantitative relevance of the ‘temporariness’ hypothesis by comparing the predictions of a simple model to the actual figures for seven major programs. The paper concludes that nominal interest rates must fall substantially for the ‘temporariness’ hypothesis to account for an important fraction of the observed consumption booms.

Dollarization in Transition Economies: Evidence and Policy Implications

After most restrictions on foreign currency holdings were relaxed in the early 1990s, foreign currency deposits in transition economies have been increasing rapidly. This paper takes a first look at the evidence on dollarization for 15 transition economies, and then discusses some key conceptual and policy implications. Depending on the institutional constraints, foreign currency deposits as a proportion of broad money reached a peak of between 30 and 60 percent in 1992-93. Unlike what has been observed in Latin America, however, dollarization has fallen substantially in the aftermath of successful stabilization plans in Estonia, Lithuania, Mongolia, and Poland. Since foreign currency deposits reflect mainly a portfolio choice, the fall in dollarization can be primarily attributed to higher real returns on domestic-currency assets, as a result of lower inflation and more market-determined interest rates.

Stabilization dynamics and backward-looking contracts

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.

The optimal inflation tax when money reduces transactions costs: A reconsideration

Abstract It has been argued that, if money acts as an intermediate good, the optimal inflation tax is zero. This paper reexamines such a claim in the context of a model in which money reduces transactions costs. It is shown that modeling money as an intermediate good does not necessarily imply that the optimal inflation tax is zero. The optimality of a zero inflation tax depends on the properties of the transactions costs technology. In particular, if the transactions costs technology does not exhibit constant returns to scale, it is optimal to resort to the inflation tax.

The optimal inflation tax in the presence of currency substitution

Abstract An important result in the optimal inflation tax literature is that, if money is modeled as reducing transactions costs, the optimal nominal interest rate is zero. This paper examines this issue in the context of a small open economy where both domestic and foreign currency circulate as media of exchange. It is shown that the presence of foreign money enables the government to reduce the distortion introduced into the economy by a positive foreign nominal interest rate by setting a positive domestic nominal interest rate.

Macroeconomic Interdependence under Capital Controls: A Two-Country Model of Dual Exchange Rates

This paper studies the transmission of monetary and fiscal disturbances under capital controls that are implemented via dual exchange rates. The results are contrasted with those under fixed exchange rates and perfect capital mobility. While under perfect capital mobility, permanent policy disturbances have no real effects abroad and the adjustment is instantaneous, under dual exchange rates, these disturbances are transmitted abroad and adjustment is gradual. The co-movement of both domestic and foreign consumption and domestic and foreign real interest rates is negative during the transition period, independently of the type of disturbance.

Inflation and stabilization in transition economies: An analytical interpretation of the evidence

A simple model is developed to understand inflationary pressures and stabilization in non-market economies. It is shown that in the typical planned economy, the endogeneity of the money supply and the over-determination of the system (given that both prices and wages are set by the planners) imply that a permanent increase in wages leads to an ever-increasing monetary overhang. The model also suggests that price liberalization should lead to a price level overshooting provided that wages remain a nominal anchor. In light of the model, the paper reviews the inflation and stabilization experiences of several transition economies in Eastern Europe and the former Soviet Union. The paper concludes that (i) transition economies have suffered from essentially the same inflationary pressures as did planned economies, and (ii) the exchange rate has been more effective than money as a nominal anchor in reducing inflation

Inflationary finance and currency substitution in a public finance framework

Abstract This paper analyzes the impact of currency substitution on inflationary finance in a public finance framework. It is shown that if foreign money balances can be taxed (or subsidized), the optimal inflation tax is always zero. In the more realistic case in which foreign money cannot be taxed, the optimal inflation tax is positive whenever there are revenue needs. Moreover, the optimal inflation tax is an increasing function of government spending and the foreign nominal interest rate.