Disinflation programs under policy uncertainty

Abstract

This paper uses a model with endogenous labor supply to study exchange rate-based inflation stabilization programs under uncertainty regarding the duration of the program. The paper finds that the output and consumption dynamics induced by these programs are extremely sensitive to whether the programs are perceived to have a chance of continuing permanently or whether they are expected to end in finite time. It is shown that the business cycle dynamics for output that are typically associated with these programs arise only when the policy is expected to collapse in finite time. Furthermore, for the purposes of rationalizing the stylized facts, the uncertain duration channel appears to induce a fundamental tension between the consumption dynamics and the current account dynamics. These results raise doubts regarding the explanatory power of the uncertain duration channel in particular and the credibility channel in general.