Chapter 5
Inflation and Disinflation
© Pierre-Richard Agénor
The World Bank
1




Sources of Inflation
Nominal Anchors in Disinflation Money vs. the
Exchange Rate
Disinflation Programs: The Role of Credibility
Two Recent Stabilization Experiments
2
Sources of Inflation



Hyperinflation and chronic Inflation
Fiscal Deficits, Seigniorage, and Inflation
Other sources of Chronic Inflation
 Wage Inertia
 Exchange Rates and the Terms of Trade
 The Frequency of Price Adjustment
 Food Prices
 Time Inconsistency and the Inflationary Bias
3
Hyperinflation and Chronic Inflation




Cagan's criterion: Hyperinflation is defined as an
inflation rate of at least 50% per month, or 12,975%
per annum.
Three main features of hyperinflation (Végh,
1992):
It typically has its origin in large fiscal imbalances.
Nominal inertia tends to disappear.
It brings about a chaotic social and economic
environment.
4




Example of hyperinflation: Zaire.
A deep and worsening political crisis led to a drastic
increase in government expenditure.
At the peak of the hyperinflation process, in
December 1993, inflation rose to almost 240% a
month.
During the whole period, domestic prices were
increasingly set in foreign currency.
Figure 5.1: during the whole episode, the monthly
rate of depreciation of the parallel exchange rate
remained closely correlated with the inflation rate.
5
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7




Features of chronic inflation:
Fiscal imbalances are often less acute in the short
run than those observed during episodes of
hyperinflation; in this case more difficult to
mobilize political support for reform.
There is a high degree of inflation inertia resulting
from widespread indexation of wages and financial
assets.
The public is often skeptical of new attempts to
stop inflation, particularly when there is a history of
failed stabilization efforts.
Lack of credibility can be a source of inertia.
8
Fiscal Deficits, Seigniorage,
and Inflation




In countries where the tax collection system, capital
markets, and institutions are underdeveloped, fiscal
imbalances are often at the root of hyperinflation
and chronic inflation.
Governments often have no other option but to
monetize their budget deficits.
Bruno and Fischer (1990): how monetary growth
and fiscal deficits affect inflation.
Suppose: real money demand, md, is a function of
the expected inflation rate, a.
9


Under perfect foresight expected and actual
inflation rates are equal,  = a.
Money demand:
md = m0exp(-).

At equilibrium, m = ms = md. This implies:
 = - [ ln(m/m0)/ ].


Along an equilibrium path, inflation and real money
balances are negatively related.
Downward-sloping curve in the -m space,
10
denoted MM in Figure 5.2.
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12

Real fiscal deficit:
d = dA + ,

 > 0,
dA: autonomous component of the deficit;
: measure Olivera-Tanzi effect (rise in the
inflation rate lowers the real value of tax revenue as
a result of the lag involved in collecting taxes).
Deficit must be financed by seigniorage revenue:
.
d = m,
  M/M : rate of growth of the nominal money
stock.
13

Rate of change of real money balances:
.
m/m =  - .

.
After substitution, in steady state with m/m = 0,  =
:
 = [dA /(m - )],
which implies that inflation and real money
balances are negatively related in equilibrium (DD
in figure 5.2).
14





Economy moves along MM in the short run; MM
intersects DD only when the economy reaches its
long-run equilibrium position (constant level of
real money balances).
Depending on the size of dA, MM and DD may or
may not intersect.
Figure 5.2 illustrates three cases:
two equilibria, corresponding to curve DD;
one equilibrium, corresponding to curve D´D´;
no equilibrium, corresponding to curve D´´D´´.
15






Under what conditions is the long-run equilibrium
unique?
Suppose  = 0. In steady state, m = dA.
As dA increases, steady-state seigniorage revenue
(inflation tax) must increase as well.
But the relationship is nonlinear because as
inflation rises, real money demand falls.
Exponential form of the money demand function:
when inflation begins to rise, real money balances
fall by relatively little, and revenue from the inflation
tax increases at first.
As inflation continues to rise, real money balances
begin to fall at a rate faster than the rate at which
16
inflation rises.





Thus, after a phase during which m increases (at a
decreasing rate), it starts falling (at an increasing
rate) and eventually tends to zero as  goes to
infinity.
These results define a concave relationship:
seigniorage Laffer curve associating the steadystate , and m = dA.
Figure 5.2: for some level of dA, there are two
corresponding rates of inflation, one low one high.
MM and DD curves in that case intersect twice.
Uniqueness occurs only at the optimal inflation
rate, max: maximizes steady-state seigniorage.
17

Revenue-maximizing rate of inflation is reached:
- [(dm/m)/(d/)] = m/ = 1.

m/: elasticity of real money demand with respect to
inflation.
Optimal inflation rate:
max = 1/,
: inflation elasticity of money demand.
18

Level of dAm in this case:
m
dA =




(m0exp(-1) - )/.
When  < max, increases in  raise revenue from
the inflation tax: ( d(m) / d > 0 and m/ < 1).
When  > max, increases in  decrease revenue
from the inflation tax: ( d(m) / d < 0 and m/ > 1).
Is the solution stable?
Equilibrium with a lower inflation rate is unstable.
19





This means that any disturbance or exogenous
shock will lead the economy away from low inflation
equilibrium point.
But, high inflation equilibrium is stable.
Given the nature of the adjustment process under
perfect foresight, a country can be stuck in a
situation in which inflation is persistently high:
inflation trap (Bruno and Fischer, 1990).
Any equilibrium characterized by  > max is
inefficient: the same amount of revenue could be
collected at a lower inflation rate.
What can governments do to move the economy
away from an inefficient position?
20





Change either dA or , because both affect the
position of the economy along the seigniorage
Laffer curve.
For instance, a credible reduction in the money
growth rate may shift MM and DD in such a way
that the MM curve will intersect the DD curve only
once.
Figure 5.3: positive relation between inflation and
seigniorage.
Figure 5.4: positive relation between inflation and
broad money growth.
De Haan and Zelhorst (1990) and Karras (1994b):
link between monetary growth and budget deficits in
developing countries.
21
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


Conclusion: only in a small number of cases does a
close, positive relationship exist.
Explanation: role played by expectations about
future policy changes (Kawai and Maccini, 1990).
Criticism for public finance approach to
inflation:
Since
 taxation is an alternative to money creation;
 marginal cost of taxation is moderate relative to
the welfare costs of extreme inflation;
high money growth (and therefore high inflation) is
not optimal.
24
Other Sources of Chronic Inflation





In addition to fiscal deficits and money growth,
other factors that can affect the inflationary process
in the short run:
Wage inertia
Exchange rates and the terms of trade
The frequency of price adjustment
Food prices
Time inconsistency and the inflation bias
25
Wage Inertia


Backward-looking wage formation mechanisms
(e.g. wage indexation on past inflation rates) can
play an important role in inflation persistence.
Model: economy produces home goods and
tradable goods.
26

The inflation rate, , is given by a weighted
average of changes in prices of both categories of
goods:
 = N + (1 - ) ( + *T)
0 <  < 1,
: share of home goods in the price index,
N: rate of change in prices of home goods,
*T: rate of change in prices of tradables,
: devaluation rate.
27

Changes in prices of home goods are set as a
^ and the
mark-up over nominal wage growth, w,
level of excess demand for home goods, dN:
^ + d .
N = w
N

Nominal wage growth is determined through
indexation on past inflation as follows:
^ =  0 <   1,
w
-1
with  = 1 denoting full indexation.
28

Inflation:
 = -1+ dN + (1 - )( + *T),
inflation inertia exists as long as  is positive.


Agénor and Montiel (1999): experience of countries
like Chile in the early 1980s and more recently
Brazil has shown that backward-looking wage
indexation can contribute to inflation inertia.
In some countries: frequency at which nominal
wages are adjusted tends to increase with the
inflationary pressures generated by exchange rate
movements.
29


Exogenous shocks in the wage bargaining
process could also exert independent impulse
effects on inflation.
This could persist over time in the presence of an
accommodative monetary policy.
30
Exchange rates and the terms of trade


Nominal exchange rate depreciation can exert
direct effects on the fiscal deficit through two
channels:
 by affecting the domestic-currency value of
foreign exchange receipts by the government
and foreign exchange outlays;
 by affecting the revenue derived from ad
valorem taxes on imports.
Since depreciation raises the prices of importcompeting goods and exportables, it may exert
pressure on wages due to its effect on the cost of
living.
31




This is likely to occur in a setting in which indexation
mechanisms are pervasive.
Example: a country facing a sharp deterioration in
competitiveness and a large current account deficit
and policymakers decide to devalue the exchange
rate.
Devaluation will increase both the domesticcurrency price of imported final goods as well as
imported inputs. This puts upward pressure on
domestic prices.
Increase in prices can be large enough to outweigh
the effect of the initial devaluation on
competitiveness---thereby prompting policymakers
to devalue again.
32





The process can therefore turn into a devaluationinflation spiral.
If wages are indexed on the cost of living, they will
increase also, putting further upward pressure on
prices of domestic goods.
Evidence: Onis and Ozmucur (1990) for Turkey;
Alba and Papell (1998) for Malaysia, the
Philippines, and Singapore.
Similar process can be seen in countries where the
official exchange rate is fixed but the parallel
market for foreign exchange is large.
Deterioration in external accounts leads agents to
expect a devaluation of the official exchange rate to
restore competitiveness.
33





Such expectations will be translated immediately
into a depreciation of the parallel exchange rate.
Because the parallel rate measures the marginal
cost of foreign exchange, domestic prices will tend
to increase.
This increase in prices will further erode
competitiveness, leading agents to expect an even
larger devaluation of the official exchange rate.
Figure 5.5: although parallel exchange rates display
a higher degree of variability than prices, the
correlation is positive in the case of Morocco and
Nigeria during the 1980s and early 1990s.
When the government is directly involved in
controlling exports of commodity, there may be: 34
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37
direct effect of changes in the terms of trade on
the budget;
 indirect effect through taxes on corporate profits
and domestic sales.
Reduction in government revenue due to negative
shock causes pressure for monetizing the fiscal
deficit.
Improvement in the terms of trade may lead to
higher inflation in the future:
 if government spending has increased sharply in
response to temporary commodity price booms
and;
 if such increases are difficult to reverse when
38
commodity prices fall.



The frequency of price adjustment



When high inflation is associated with highly
variable inflation and uncertainty over the pricing
horizon of price setters, the frequency of price
adjustment becomes endogenous and tends to
accelerate.
Shortening of the adjustment interval raises
inflation, leading to a further shortening of the
adjustment interval.
So price setters will be more and more opting to
denominate their prices in a foreign currency.
39

Dornbusch, Sturzenegger, and Wolf (1990):
increased synchronization between domestic
prices and the nominal exchange rate as inflation
rises in Bolivia, Israel, Argentina, and Brazil.
40
Food prices





In many developing countries food items comprise
the bulk of the goods included in consumer price
indices.
Consumer price index in Nigeria: food items
representing 69% of the total basket.
So supply-side factors affecting food prices have
an important effect on the behavior of prices.
Moser (1995): rainfall had a significant effect on the
rate of price increases, in addition to money growth
and exchange rate changes in Nigeria.
Figure 5.6: close correlation between inflation in
food prices and inflation in consumer prices.
41
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42
Time inconsistency
and the inflation bias



Lack of credibility may impart an inflation bias to
monetary policy.
This lack of credibility may result from the time
inconsistency problem faced by policy
announcements: a policy that is optimal ex ante
may no longer be optimal ex post.
Reason: policymakers are concern about inflation
as a policy goal and with the fact that inflation may
carry benefits.
43

Barro and Gordon (1983): policymakers are
concerned about both inflation and
unemployment, with a loss function:
L = (1/2)(y -
~2
y) +
~ 2,
(/2)( - )
 > 0,
(13)
~
y: current output, y: its desired level,
~ desired inflation rate,
: actual inflation, :
: relative importance of deviations of inflation from
its target value in the loss function.
44

Expectations-augmented Phillips curve:
y = yL + ( -
a)
+ u,
~
 > 0, yL < y
(14)
yL: long-term level of output,
a: expected inflation,
u: disturbance term with zero mean and constant
variance,
~ ensures that the policymakers have an
yL < y:
incentive to raise output above its long-run value.
45




Policymakers want private agents to expect low
inflation, in order to exploit a favorable trade-off
between inflation and output.
But the mere announcement of a policy of low
inflation is not credible, because policymakers have
an incentive to renege to increase output and
reduce unemployment and private agents
understand this renege.
Result:
inflation will in equilibrium be higher than it would be
otherwise;
monetary policy suffers from an inflation bias.
46

Substitute (14) in (13):
L=(1/2) {yL + ( ~ 2
+ (/2)( - )

a)
~
- y + u}2
(15)
With a binding commitment to low inflation,  = a;
the loss function becomes:
~ 2.
L = (1/2)(yL - y~ + u)2 + (/2)( - )
47

Under discretion, policymakers take expected
inflation as given; the first-order condition for
minimizing the expected value of (15) with respect
to  is:
~
~
=+

 (y - yL)
+
2
+
~
2
a
 ( - )
 + 2
In equilibrium,  = a (Phillips curve) :
 =  + (y - yL)/.
~
~
48

In equilibrium output can deviate from its capacity
level only as a result of random shocks:
y = yL + u.


Under discretion, the equilibrium inflation rate will
be higher than desired inflation.
~
The higher (y - yL), the higher the slope of the
Phillips curve, and the lower the relative
importance of inflation in the loss function, the
higher inflation will be.
49


Credible commitment to a policy rule is welfare
enhancing compared with a discretionary policy.
If policymakers can credibly commit themselves to
low inflation, the economy will be better off; output
will be the same as in the discretionary policy case
but inflation will be lower.
50
Nominal Anchors in
Disinflation: Money vs. the
Exchange Rate




Controllability and Effectiveness
Adjustment Paths and Relative Costs
Credibility, Fiscal Commitments, and Flexibility
The Flexibilization Stage
51



Debated issues in the analysis of disinflation
policies: relative merits of exchange-rate-based
stabilization versus the targeting of money (or
credit) growth in conjunction with exchange rate
flexibility.
When information is complete and no distortions or
rigidities are present, exchange-rate targets or
monetary targets are equivalent policies under
perfect capital mobility.
Fischer (1986): when there are multiperiod
nominal contracts, exchange-rate targets
dominate monetary targets under some
configurations of the underlying parameters.
52




Agénor and Montiel (1999): under imperfect capital
mobility, disinflation through a reduction in the
nominal devaluation rate or a fall in the rate of
growth of domestic credit are not equivalent.
Choice between the exchange rate and the
money supply as a nominal anchor depends on
three main considerations:
degree of controllability and the effectiveness of
the instrument in bringing down inflation;
adjustment path of the economy and the relative
costs associated with each instrument;
degree of credibility that each instrument
commands, and its relationship with fiscal policy.
53
Controllability and Effectiveness




Policymakers cannot control directly the money
supply, but fixing the exchange rate can be done
relatively fast and without substantial costs.
When money demand is subject to large random
shocks and velocity is unstable, the effectiveness
of the money supply as an anchor is reduced.
But an exchange rate peg will anchor the price level
through its direct impact on prices of tradables.
So fixing the exchange rate rather than the money
stock may appear preferable.
54




Monitorable target may bolster the government's
commitment to the stabilization effort and help to
move new low-inflation equilibrium (Bruno, 1991).
Policymakers must be able to convince private
agents that they are willing and able to defend the
fixed exchange rate.
Exchange rate management may be difficult to
achieve if the current account deficit is large or if
official reserves are relatively low.
Speculative attacks may occur.
55
Adjustment paths and relative costs





Money-based and exchange-rate-based
stabilization programs differ significantly.
Calvo and Végh (1993):
Exchange-rate-based stabilization programs lead to
an initial expansion and a recession later on.
Money-based programs cause initial contraction
in output.
Former pattern: boom-recession cycle since
credibility of the stabilization program is low and
perceived as temporary.
Agents, to take advantage of temporarily low prices
of tradable goods, increase spending.
56




Result: current account deficit and real exchange
rate appreciation by forcing the authorities
eventually to abandon the attempt to fix the
exchange rate.
Weak evidence in favor of large intertemporal
substitution effects.
Reinhart and Végh (1995): it can explain the
behavior of consumption for some of the programs
implemented in the 1980s, but not for the tablita
experiments of the 1970s in Argentina, Chile, and
Uruguay.
Nominal interest rates would have had to fall more
than they did to account for a sizable fraction of the
consumption boom recorded in the data.
57




Intertemporal effects were not large enough to
explain the pattern of output.
Interactions between monetary and supply-side
factors.
Roldós (1995):
Due to cash-in-advance constraint, inflation
creates a wedge between the real rate of return on
foreign-currency-denominated assets and domesticcurrency-denominated assets.
When stabilization program based on a permanent
reduction in the devaluation rate reduces the wedge
and leads to an increase in the desired capital stock
in the long run.
58





In the short run, consumption and investment
increase, causing a real appreciation, a current
account deficit, and an increase in output of home
goods.
Over time, the increase in output of tradable goods
lowers the initial current account deficit.
Not predict a recession at a later stage.
Rebelo and Végh (1997):importance of supply-side
factors (real wages).
How do the relative costs of money-based and
exchange-rate-based programs relate to their
implications for remonetization?
59




Pegged-exchange rate system:
Households and enterprises increase their real
money balances after a period of high inflation.
Increase is satisfied automatically through the
balance of payments, as agents repatriate their
capital held abroad and convert it costlessly into
domestic currency.
Money supply anchor:
No automatic mechanism for agents to rebuild their
real money balances.
Many central banks refrain from domestic credit
expansion, and the economy remains
undermonetized; high real interest rates and an
60
overvalued currency.

Result: successful anti-inflation programs under a
money supply target (and floating exchange rates)
tend to be more contractionary than under pegged
exchange rates.
61
Credibility, Fiscal Commitment,
and Flexibility



Degree of credibility of the money supply and the
exchange rate is important in choosing a nominal
anchor.
Credibility depends on:
policymakers' ability to convey clear signals about
their policy preferences;
degree of controllability of policy instruments and
the dynamic adjustment path of the economy, as
discussed earlier.
62




Public observability of the exchange rate as
opposed to monetary and credit aggregates
enhances the credibility of an exchange rate
anchor.
Money-based stabilization by an immediate
recession may lose credibility rapidly, if the shortterm output and employment cost is high.
When the exchange rate is used as a nominal
anchor, residual inflation in home goods prices
may remain high combined with the expansion of
aggregate demand, it may lead to a real
appreciation.
This immediately weakens the credibility.
63



When lack of credibility is pervasive, the choice
between money and the exchange rate may not
matter; inflation will remain high regardless of the
anchor.
An exchange-rate rule is, however, more successful
in reducing inflation if there is some degree of
credibility; initial expansion and the upward
pressure on the real exchange rate will be
dampened.
Exchange rate anchor may induce a higher
commitment to undertake stabilization measures:
fiscal adjustment.
64



If there are doubts about the government's
commitment to fiscal restraint, an exchange rate
peg would also lack credibility.
Végh (1992): ten exchange-rate-based programs
aimed at stopping high chronic inflation.
Seven of them were failures:
 Two cases: failure was due to real appreciation of
the currency following slow convergence of
inflation, in spite of achieving fiscal balance.
 Remaining five: failure to implement a lasting
fiscal adjustment was the main factor.
65
Flexibilization stage



Although a pegged exchange rate is beneficial in
stopping high inflation, maintaining it for too long
can become problematic.
Fixed nominal exchange rate, continued inflation
higher than that prevailing in trading partners
implies an appreciation of the real exchange rate
erode external competitiveness and hinder export.
Deteriorating trade performance may force the
authorities to depreciate the exchange rate and
reignite inflationary pressures.
66


Shift toward a more flexible exchange rate regime
once macroeconomic stability is achieved, is
important to adjust to internal and external shocks.
Reduced commitment to low inflation must be
renewed by fiscal and monetary discipline to
maintain credibility.
67
Disinflation Programs:
The Role of Credibility


Sources of Credibility Problems
Enhancing Credibility
 Big Bang and Gradualism
 Central Bank Independence
 Price Controls
 Aid as a Commitment Mechanism
68
Sources of credibility problems




Four different sources of credibility problems in
disinflation programs:
Inconsistency between the objective of
disinflation and the policy instruments to achieve
this objective, or sequencing of policy measures in
a reform program.
Uncertainty associated with the policy environment
and exogenous shocks.
Time inconsistency of policy announcements:
program is optimal ex ante may not be ex post.
Incomplete or asymmetric information about
policymakers' preferences.
69



Over time private agents will get to believe that
policymakers are serious about their policy goal
(learning process).
If policymakers have a long tradition of stop-and-go
policies and the rotation of policymakers in office
tends to be high, learning process will be slow.
Imperfect monitoring capability makes building
reputation by policymakers more difficult; private
agents may learn only gradually, through a
backward-induction process.
70


Agénor and Taylor (1992): two methods for
assessing the relative importance of the various
sources of lack of credibility.
Specify a model of the inflationary process in which
lagged inflation appears and estimate it with
recursive least-squares techniques:
 changes in the behavior of the coefficient of the
lagged inflation rate (inertia or persistence) can
be used to assess changes in the degree of
credibility;
 increased credibility will translate into a lower
coefficient.
71


Study of changes in the behavior of the coefficient
of a variable measuring the opportunity cost of
holding domestic money.
Assumption: increased credibility will translate into a
lower degree of persistence in the inflationary
process and in a shift toward domestic-currencydenominated assets.
72
Enhancing credibility




Four ways:
adoption of a drastic (big bang) program as a way
to signal the policymaker's commitment to
disinflation;
central bank independence;
imposition of price controls;
conditional foreign assistance.
73
Big bang and gradualism




Early phase of overadjustment as a means to
signal to skeptical agents the policymakers'
commitment to inflation stabilization.
Easier to implement in countries where a new
government with a broad anti-inflation mandate is
just being put in place.
Although initial costs of a big bang program is
high, it may be less than the costs of inflation
continuing at a higher level for a long period of time.
Adopting an overly tight policy stance may
exacerbate it because it may create expectations of
future policy reversals.
74



Such expectations may result from the
conjunction of two factors:
large short-run output and employment costs and a
consequent loss of political support;
fact that the future benefits of disinflation are
heavily discounted by the public.
In such conditions, enhancing the credibility may
require to implement politically and economically
sustainable measures instead of shock therapy.
75
Central bank independence



Independence may be critical in countries where
central bank financing of government budget
deficits is often the main source of inflation.
Factors that may mitigate the credibility gain by
central bank independence:
Legal independence does not guarantee the
absence of freedom from political interference and
pressure on the central bank's policy decisions.
Blackburn and Christensen (1989): even an
independent central bank may be willing to make
concessions to the government in order to retain its
autonomy.
76



Adhering to a rigid anti-inflation policy stance
implemented by an independent central bank may
be suboptimal in an economy subject to adverse
economic shocks.
Credibility of monetary policy may depend on the
overall stance of macroeconomic policy, rather
than on the degree of central bank independence
per se.
Independent monetary and fiscal authorities may
adopt policies that generate coordination
problems and costs that may outweigh the gain
resulting from central bank autonomy alone.
77



Alesina and Tabellini (1990):
Ambiguity of the net benefits from central bank
precommitment to low inflation.
Reason: lower inflation reduces the revenue from
inflationary finance and forces the fiscal authority to
resort to a higher level of distortionary taxation.
Early empirical studies focusing mostly on
industrial countries: whenever central banks had
the highest degree of autonomy also had the lowest
levels of inflation.
78





Measuring central bank independence
(Cukierman, 1992):
appointment mechanisms for the governor and
board of directors;
turnover of central bank governors;
approval mechanism for conducting monetary policy
statutory requirements of the central bank regarding
its basic aim and financing of the budget deficit
existence of a ceiling on total government borrowing
from the central bank.
79



Recent empirical literature: no robust association
between central bank independence and inflation
performance in industrial countries (Forder (1998)).
Sikken and De Haan (1998):
For developing countries.
Measuring central bank independence using
various indicators:
Synthetic legal measure (Cukierman, 1992):
 variables related to the appointment, dismissal,
and term of office of the governor of the central
bank;
80
variables related to the resolution of conflicts
between the executive branch and the central
bank over monetary policy and the participation
of the central bank in the budgetary process;
 final objectives of the central bank, as stated in
its charter;
 legal restrictions on the ability of the public sector
to borrow from the central bank.
Turnover rate of central bank governors, which
attempts to capture actual independence.
Political vulnerability index: fraction of political
transitions that are followed within six months by a
replacement of the central bank governor.



81


Sikken and de Haan: no evidence that central bank
independence creates an incentive for governments
to maintain low fiscal deficits.
Found: measures of independence are not clearly
related to the degree of monetization of government
budget deficits by the central bank.
82
Price controls





Case when inflationary process is characterized by
substantial inertia, stemming from explicit or
implicit indexation.
This is a common feature of economies suffering
from chronically high inflation.
Arguments in favor of temporary price controls
(Dornbusch, Sturzenegger, and Wolf , 1990):
Realignment device: when pricing decisions are
not instantaneous, price controls may help realign
prices quickly and correct price distortions.
Coordination device: price controls help
coordinate expectations toward a low inflation
83
path.




Fiscal device: Reverse Olivera-Tanzi effect:
 transition from high to low inflation yields an
immediate gain in real revenue from taxation.
 Lower the borrowing needs of the government
from the central bank.
Price controls may help enhance credibility by
serving as an additional nominal anchor.
Blejer and Liviatan (1987): price controls may give
policymakers some breathing room.
Persson and van Wijnbergen (1993): price controls
may help policymakers to reduce the cost of
signaling their commitment to low inflation.
84



Successful temporary application of price
controls: Israeli stabilization of 1985.
All nominal variables, including the exchange rate,
were frozen.
With a sharp fiscal contraction and a restrictive
monetary policy, price controls led to a quick
reduction in inflation and enhanced government
credibility, without a severe economic contraction.
Criticism of price controls:
Use of price controls may be counterproductive
because they do not enable the public to learn
whether inflation has really been stopped.
85




Credibility-enhancing effect of price controls may
vanish if policymakers are unwilling or unable to
control all prices in the economy (Agénor, 1995).
In this case price controls may lead to inflation
inertia.
Problems at the practical level:
Price controls have often been used as a
substitute, rather than a complement to fiscal and
monetary adjustment.
Repeated use of price controls diminished their
effectiveness, as economic agents anticipated the
price increases that would follow the flexibilization
stage.
86
Aid as a commitment mechanism



Enhance credibility and the probability of program
success by subjecting to an external enforcement
agency whose commitment to low inflation is well
established (e.g. IMF).
They provide foreign assistance conditional on
attaining specific macroeconomic policy targets.
Difficulties arise in judging the credibilityenhancing effect of foreign assistance:
Political considerations often play a role in
deciding whether particular countries should receive
external financial assistance support.
87

Conditionality is a double-edged sword. If the
degree of conditionality attached to foreign aid is
perceived to be excessive, uncertainty about
external support may rise (Orphanides (1996)).
88
Two Recent stabilization
Experiments





Egypt, 1992-97
Uganda, 1987-95
Egypt: exchange-rate-based stabilization.
Uganda: money-based approach.
Both show the role of fiscal adjustment in
stabilization programs.
89
Egypt, 1992-97




Macroeconomic imbalances faced by Egypt
(Figure 5.7):
Although inflation was not high, the fiscal deficit and
money growth rate were high.
Dollarization ratio (share of foreign currency
deposits in total bank deposits) grew to about 46%
in 1990.
Depreciation of about 30% between 1986 and 1991
of the real effective exchange rate.
Current account deficit reached about 10% in
1990/91.
90
F
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5
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91
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92
F
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5
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130
N
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3
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;
a
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p
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a
t
i
o
n
.
93



Gross external debt increased to 147% of GDP
during the period 1988/89-1990/91.
Program of macroeconomic stabilization and
structural reform was implemented in 1991.
Key features:
combination of fiscal, monetary, and credit policies
together with an exchange rate anchor policy which
was viewed as a way of:
 signaling the government's commitment to
disinflate;
 limiting pass-through effects of nominal
exchange rate changes on prices.
94




Substantial adjustment of fiscal accounts
through:
general sales tax was introduced and a global
income tax reform was implemented;
domestic-currency value of oil revenues and Suez
Canal receipts as well as taxes on imports
increased;
cuts in public expenditure;
debt forgiveness and rescheduling agreement.
95








Results:
overall deficit of the government declined sharply;
primary fiscal balance of the government improved;
gross domestic public debt fell;
sharp reduction in broad money growth;
rate of inflation declined;
improvement in external accounts and a substantial
accumulation of foreign reserves;
appreciation of real effective exchange rate;
dollarization ratio fell.
96



Output cost of disinflation was a short-lived
recession: real GDP growth dropped to 1.1% in
1990/91 but rebounded to 4.6% in 1994/95 and 5%
on average for 1995/96-1996/97.
This reflected two factors:
Real credit growth to the nongovernment sector
remained positive throughout the stabilization
program.
Although interest rates were liberalized in early
1991 and jumped to high levels, they went down
very quickly.
97




Key lessons:
Importance of fiscal adjustment and external
factors.
Debt reduction and write-offs contributed to
significantly to fiscal adjustment and improvements
in the country's external accounts---despite an
appreciating real exchange rate.
Tighter policies, with a potentially higher output
cost, would have been needed otherwise if the
external constraint had been more severe.
External assistance played an essential role in
helping the program gain credibility rapidly.
98
Uganda, 1987-95





Economic problems before applying the
program:
In 1986, per capita GDP was estimated to be at
about 50% below the level of 1970.
Inflation was high.
Fixed exchange rate regime led to a significant real
appreciation and a loss of competitiveness.
Foreign exchange shortages led to a considerable
spread between the official exchange rate and the
parallel market exchange rate.
Deterioration in terms of trade.
99






In 1987: structural adjustment package, Economic
Recovery Program, was applied.
Stabilization took place through a tightening of
monetary and fiscal policies.
Currency depreciation was accompanied by a
substantial increase in producer prices.
Import restrictions were removed.
GDP growth responded quickly to the adjustment
measures (Figure 5.8).
But inflation remained high.Main factors behind this
result:
 insufficient effort to tighten fiscal policy;
 excessive growth of bank credit to the
100
government.
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101
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102
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2
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;
a
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a
t
i
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n
.
103



Lack of fiscal adjustment and price stabilization and
an improvement in external accounts reflected:
 maintenance of an overvalued exchange rate;
 difficult external environment.
Major deterioration in terms of trade during
1987/88 to 1992/93.
Lack of foreign exchange led to an accumulation of
external arrears and an expansion of parallel
currency markets.
104







Corrective actions during 1989/90 and
1990/91:
Devaluation took place.
Government spending was cut, tax revenues
increased.
Improvement in the fiscal position led to a reduction
in credit expansion and money supply growth.
As a result, inflation dropped.
Liberalizing domestic prices and the exchange
system led to production of noncoffee products.
Current account improved.
But inflation increased again because of:
 weather-related supply factors;
105
renewed pressure on domestic credit growth to
the government.
Fiscal and monetary discipline returned during
the period 1992/93 to 1994/95:
strict expenditure control was accompanied with
revenue measures and improved tax administration;
foreign exchange market was unified with the
introduction of an interbank market;
restrictions on current international transactions
were eliminated; this led to strong investment
incentives to exporters and to large private capital
inflows.




106




Result:
prices actually fell;
foreign exchange market was further liberalized;
real output growth increased;
external current account deficit fell.
107

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Key results of Egypt and Uganda experiences:
Fiscal adjustment played a key role.
This led to maintenance of money supply and
taming of inflation.
Without a significant reduction in fiscal imbalances,
stabilization cannot last regardless of the anchor
chosen.
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Other results:
Composition of fiscal adjustment has important
implications for growth.
Importance of whether the fiscal deficit is reduced
by cutting unproductive expenditure or by raising a
tax is that high rates of taxation levied on a narrow
tax base foster tax evasion and may lead to an
informal economy, exacerbating fiscal constraints
in the longer run.
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