Real Interest Rates during the Disinflation Process in Developing Countries

Abstract

This paper addresses a phenomenon often noted in association with programs aimed at stabilizing high rates of inflation: a rise in the ex post real interest rate following implementation of the disinflation strategy. Such increases have been observed in connection with the stopping of European hyperinflations in the 1920s, as well as during the more recent experiences of disinflation in Argentina and Israel. To better understand this behavior, we develop a very general model of interest rate determination in a small open economy with two goods--traded and non-traded--and three assets--money, domestic bonds, and foreign bonds. We show that in partial portfolio equilibrium, a reduction in the fiscal deficit leads to a fall in inflation exceeding the decline in nominal interest rates, so the real interest rate rises; this effect derives from the increase in money demand resulting from the disinflation. In partial goods-market equilibrium, however, a reduction in the fiscal deficit reduces goods demands and lowers the real interest rate. In consequence, the general equilibrium response of the real interest rate to a disinflation program based on fiscal contraction is shown to be indeterminate.The framework described above is used to examine the response of real interest rates to Argentina's disinflation in 1985. We show that the reduction in the fiscal deficit, as well as the government's shift away from money-financing, should have increased real interest rates substantially. However, the imposition of the Austral Plan appears to have exerted an independent effect in reducing interest rates, so that the impact of the program on the real rate of interest was largely neutralized.