Stabilizations, crises and the “exit” problem – A theoretical model

Abstract

Exchange-rate-based stabilizations, even if successful, usually lack credibility initially. This is reflected in high (ex post) real interest rates and some degree of real exchange rate appreciation. Empirical observation suggests that wage inflation declines smoothly over time whilst interest rates are volatile. Our model captures these features and provides insights into: the eruption of exchange rate crises after a long period of apparently successful stabilization; the potential advantages of a heterodox approach; when to delay a stabilization attempt; and the optimal date for “exit” to a floating exchange rate.