Working Paper

Habit formation and the comovement of prices and consumption during exchange-rate based stabilization programs

Abstract: A defining stylized fact associated with exchange-rate-based (ERB) stabilization programs is that their initial phase is characterized by several years of expansion in private consumption and a gradual appreciation of the real exchange rate. In this paper, I argue that standard optimizing models are unable to account for this empirical regularity, as they predict that, except for the date of announcement of the program, an appreciation of the real exchange rate must necessarily be accompanied by a decline in consumption. I show that this price-consumption problem can be resolved by relaxing the assumption of time separability in preferences. Specifically, under habit formation a permanent ERB program generates a smooth boom in consumption and gradual real exchange rate appreciation. A temporary program induces, in addition, a smooth boom-recession cycle with the recession beginning before the abandonment of the program.

Keywords: Consumption (Economics); Prices; Foreign exchange;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 1997

Number: 598