Lecture Notes 10

Inflation Stabilization

Prof. Metin Ercan

Inflation Stabilization
What is inflation?
• It is a condition of continually rising (aggregate)
price level

Types of inflation
• Hyper inflation
• Chronic inflation

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Hyperinflation
• The rate of inflation oscillates freely, before accelerating
exponentially in the last six months or so (It is identified with
astronomical rates of inflation)
• Some examples:
Until very recently, hyperinflation was associated with a foreign war,
civil war or political revolution. It is mainly caused by heavy
disruptions and reparation payments resulting from the war. Massive
fiscal deficits (when government outlays exceed government
revenues are financed through monetary financing (i.e. by printing))
After World War I, Austria, Germany, Hungary, Russia,
II, Hungary, Greece and China
• In 1985, Bolivia faced first hyperinflation not related to war (political
instability)
(Debt crisis stopped the foreign credit and government resorted to
monetary financing)

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Chronic Inflation
a) May last long periods of time, not in terms of
months but in terms of years
b) Has an intermediate intensity
• Higher than that of moderate inflation but
much lower than that of hyperinflation
• In normal case, such inflation does not have a
propensity to accelerate. Even if increases, it
soon reaches a new plateau

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Chronic Inflation (cont’d)
End Result of Chronic Inflation
• Learning how to live with high and persistent
inflation by creating various indexation
mechanisms
Examples
• Argentina, Brazil, Uruguay, Latin American
countries, Turkey between 1987 and 2002

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How to Stop Hyperinflation
• Price stability is the immediate result of using
the exchange rate as the nominal anchor.
Virtually all prices are indexed to the dollar
• If you stabilize the exchange rate, it is easy to
achieve price stability
• Of course if permanent fiscal measures are not
taken, inflation may resume shortly (Greek
stabilization in 1946)

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How to Stop Hyperinflation (cont’d)
• Empirical evidence suggests
1) Inflation stops abruptly
(In some countries, virtually achieved overnight
following exchange rate stabilization)
2) It is stopped at relatively small cost compared
to chronic-inflation countries

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How to Stop Hyperinflation (cont’d)
Why?
• No backward indexation
• There is no inflation inertia resulting from backward
looking behavior (i.e. there is no clear linkage between
past and tomorrow)
• Wage contracts, for instance, are renegotiated more
frequently as inflation accelerates. At first, wage
readjustments are based on a cost of living idea. As the
interval between readjustments becomes shorter, it is
replaced by another index that is available on a weekly
or daily basis
 De facto indexation of all prices to the foreign
exchange implies that longer term contracts virtually do
not exist

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How to Stop Hyperinflation (cont’d)
Why?
• High credibility of stabilization program
a) The cause of inflationary process is better identified
(Relationship between inflation and fiscal deficit is
clearer). A stability program that includes a fiscal
reform could bring a high degree of credibility

b) Hyperinflation creates such a chaotic social and

economic environment that the public become
convinced that something needs to be done (sense of
urgency in tackling the problem)

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How to Stop Chronic Inflation
I) Stabilization program
By approaches: 1) Populist, 2) Orthodox, 3) Heterodox
By methods:
a) Exchange rate-based stabilization
b) Money-based stabilization
c) Multiple supplementary anchors
d) Multiple anchors (combination of monetary, credit constraints and
income policies)
II) Structural adjustment
a) Privatization
b) Tax reform
c) Agricultural sector reform
d) Social security reform etc.
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Stabilization Program by Approaches
1. Populist approach
• Concerned with forced price and wage control
without addressing root problems that may have
caused fiscal deficits
• From the outset it is bound to failure
• Example: Stabilization by Allende in Chile in
1970-73
• Garcia stabilization in Peru in 1986-90

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Stabilization Program by Approaches (cont’d)
2. Orthodox program
• No price or wage controls
• Tackles budget deficit problem
• Tightens monetary aggregates
• Slows down the depreciation of local currency
• In the late 70’s in Argentina, Chile and
Uruguay. They announced a devaluation
schedule (‘tablita’ or little table) against the
dollar with a decreasing rate of devaluation
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Stabilization Program by Approaches (cont’d)
3. Heterodox programs
• Instead of waiting for the effects of stabilization in
the medium term, freeze prices and wages for a
short period of time (say 6 months). This would
require a consensus by all layers in the society
• Ex: Argentina ‘85, Brazil ‘80, Israel ‘86, Mexico
‘87
• Use of wage and price controls to counter the
inertia. Main obstacle due to close linkage
between past and future

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Stabilization Program by Approaches (cont’d)
To sum up, all stabilization programs are
designed to:
• Decrease fiscal deficit
• Monitor monetary expansion
• Link depreciation of local currency to inflation

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Stabilization Program by Methods
Exchange rate-based stabilization
• They use exchange rate as a control mechanism (anchor) in fighting
inflation
Main characteristics
a) Slow convergence of inflation to the rate of devaluation
- Initial belief that inflation rate would quickly converge to the world
inflation plus the preset rate of devaluation
- However, such convergence is slow because of inertia. That’s why
it is argued that wage and price control should also be included in
the stabilization package
- Fiscal adjustment was viewed as a necessary but not sufficient
condition for a successful stabilization attempt due to inertial
components of inflation
b) Sustained real appreciation of the domestic currency
Given the slow convergence of inflation, no surprise that domestic
currency has appreciated substantially in real terms
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Stabilization Program by Methods (cont’d)
Exchange rate-based stabilization (cont’d)
c) Deterioration of trade balance and the current
account
Trade account is worsened especially by
imports of durable goods.
d) Real activity increases at the beginning of the
program and later contracts. Output costs are
paid at a later stage – ‘recession later’
e) Ambiguous response of domestic real interest
rate
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Stabilization Program by Methods (cont’d)
Money Based Stabilization
• Few programs have used it
• Chilean Plan (1975), Bonex Plan in Argentina
(1989), Collor Plan in Brazil (1990), Peru and
Dominican Republic plans
• Since only a few examples exist, findings are
not conclusive. However, they are indicative

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Stabilization Program by Methods (cont’d)
Money Based Stabilization (cont’d)
Main Characteristics:
a) Slow convergence of inflation to the rate of monetary
growth
(Inflation persisted in some money-based programs,
although it seemed to converge more quickly than in
exchange rate based programs)
b) Real appreciation of the domestic currency
c) No clear-cut responses in trade balance and current
account
d) Initial increase in domestic real interest rates
e) Initial contraction in economic activity (output costs
are paid up front – ‘recession now’)
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Stabilization Program by Methods (cont’d)
Summary:
Exchange rate-based stabilization
• Policy-makers announce a reduction in the rate of
devaluation (If it is fully credible i.e., if the public
believes the reduction in the devaluation rate will be
permanent)
• Inflation rate falls to the new equilibrium value
determined by the lower rate of devaluation
Money based stabilization
• Start with announcement for a reduction in the growth
rate of money supply
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Stabilization Program by Methods (cont’d)
Summary (cont’d):
Multiple anchors
a) Tight monetary and credit policy
• Too much liquidity in the initial stages of an exchange rate-based
program may prove dangerous because it finances more
consumption
• For example Israeli approach in ’85 includes an explicit target for
bank credit (reserve requirements were increased), higher discount
rate and a tightening of existing controls on short-term capital flow
• Results: Sharp initial increase in real interest rates, real appreciation
rates and initial recession
b) Price and Wage Controls
• Inflation inertia (resistance) defined as inflation of non-traded goods
that remain above the growth rate of the nominal anchor
• Inflation inertia results from a lack of credibility and widespread
backward indexation
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Policy Implications of Inflation Stabilization Programs
1) Fiscal adjustment is necessary but not sufficient to
have a sustainable lower inflation rate. However,
without any sound fiscal program, it is unlikely to
lower inflation rate

2) If the public is highly skeptical, about the duration of

the program, it is better to use money-based
strategy. Lower credibility reduces the benefits in
both strategies but the real disruptions are magnified
in exchange rate-based stabilization. However, if
credibility is high (because there is a new
administration taking over, for example), the
exchange rate should be favored as the nominal
anchor
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Policy Implications of Inflation Stabilization Programs (cont’d)

3) Do not attempt to pursue disinflationary policy

while maintaining a competitive real exchange
rate
• In pursuing stabilization programs, domestic
currency almost always appreciates in real
terms
• You should postpone correcting real
appreciation, otherwise your credibility is
undermined
• That’s why, initial large devaluations are done
to compensate for inevitable real appreciations
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Policy Implications of Inflation Stabilization Programs (cont’d)

4) Credibility is crucial in the success.

Policymakers should be able to convince the
public that such a policy will be sustained over
time
5) In countries with currency substitution
phenomenon, exchange rate is more attractive
as the nominal anchor
6) In heterodox programs, the response is
quicker as long as the budget deficit is also
controlled

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