Discussion Paper

The syndrome of exchange-rate-based stabilizations and the uncertain duration of currency pegs

Abstract: This paper shows that some key stylized facts of exchange-rate-based stabilization plans can be explained by the uncertain duration of the plans themselves. Uncertain duration is modeled to reflect evidence showing that devaluation probabilities are higher when the plans are introduced and abandoned than in the period in between. If contingent-claims markets are incomplete, this uncertain duration distortion introduces temporary fiscal cuts with large wealth effects. Investment and employment are also distorted, and the resulting supply-side effects play a critical role. Stabilizations of uncertain duration entail large welfare costs, but they are preferred to persistent high inflation. Mexico's experience is examined in the light of these predictions.

Keywords: Money; Foreign exchange - Law and legislation; Foreign exchange rates;

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Discussion Paper / Institute for Empirical Macroeconomics

Publication Date: 1997

Number: 121