Exchange Rate-based Stabilization Research Articles

Macroeconomic Developments and Exchange-Rate Policy in Turkey, 1980-2001

Turkey introduced an exchange-rate-based stabilization (ERBS) program in January 2000. The program seemed to be on track until the economy was hit by a sudden attack on the Turkish currency in November 2000. After a few months of muddling through, a second attack hit the currency in late February and Turkey declared that it was going to implement a floating exchange rate regime from that date onwards. This was not the first time experience with the ERBS however. In fact, since 1980 authorities have been using exchange rate in order to stabilize the economy even if such an announcement has been avoided most of the time. This article analyzes macroeconomic developments in Turkey in the period of 1980-2001 and provides a rationale for why policymakers need to support their exchange rate arrangement with other economic policies that the arrangement requires. Although, a properly valued exchange rate is critical for sound economic management and sustained growth, it’s the adoption of appropriate monetary and fiscal policies that ultimately will ensure macroeconomic stability. Since 1980, exchange rate has been used as the main stabilization instrument in Turkey. But it has never been supplemented with the necessary macroeconomic policies to ensure its success.

The Great Debate on Exchange Rate Regimes: Why Should the Mena Region Care?

Subscribing to the view that the choice of the Exchange rate regime is crucial for growth and long term development, this paper reviews the experiences of seven MENA countries with exchange rate-based stabilization and explores the future prospects for their graduation to more flexible regimes. The evidence is mixed with some (Egypt, Iran, Sudan, and Turkey) experiencing high and extended episodes of real exchange rate overvaluations, associated with a combination of high inflation inertia, unstable or pegged exchange rate regimes. The unsustainable overvaluations eventually contributed to the collapse of the pegged regimes in Egypt and Turkey. The other three (Jordan, Morocco, and Tunisia) are able to maintain very competitive exchange rates while avoiding high inflationary pressures, despite that the first two have pursued relatively rigid pegged regimes. The analysis of this paper suggests that the MENA countries would need to consider: more flexible exchange rate regimes in a world of high private capital flows; implement much stronger policy fundamentals; emulate Chile and Malaysia and only use capital control as complimentary to, not a substitute for, sound policies; select the “appropriate” exchange rate regime that would minimize the likelihood of speculative attacks and crises without sacrificing the long term goal of real exchange rate competitiveness. Finally, there is no one-size-fits all regime, and depending on country-specific characteristics, such 'appropriate' regime might be 'managed floating plus' or 'free floating' with inflation targeting; a modified target zone regime, along the lines of the BBC proposal; or even a variant of the pegged regime, following the Malaysian model.

The business cycle in postwar Lebanon

AbstractThe postwar business cycle in Lebanon was dominated by the exchange rate based stabilization (ERBS) program implemented by the successive postwar governments. In the early period 1993–2002, a boom‐bust dynamics was generated during which the economy exhibited the well‐documented stylised facts of ERBS programs. The paper develops a cyclical index (ci) for Lebanon during this period and a VAR model shows that real interest rates (rr) had a significant impact on the dynamics of the business cycle during the early ERBS period. The second period 2002–2005 was marked by a recovery generated by foreign aid given to Lebanon in the Paris II international donors' conference held in November 2002. The period ended in a recession in 2005 brought about by the assassination of Lebanon's ex‐prime minister Rafic Hariri. The third phase of the business cycle was caused by the Israel–Lebanon war in the summer of 2006 which led to widespread civilian and infrastructure damage and ended a brief recovery in early 2006. Throughout the period 2002–2006, foreign aid was instrumental in the resilience of the ERBS program. Copyright © 2007 John Wiley & Sons, Ltd.

Exchange Rate-Based Stabilization in War-Ravaged Economies The Case of Lebanon

This article examines exchange rate-based stabilization in an economy that has been badly destroyed by war or other calamities. The article does this in the context of post-civil war Lebanon. Both Iraq and Afghanistan are prime candidates for such a policy. This article first demonstrates the validity of the theory and empirical regularities (initial boom followed by an economic contraction) in the case of Lebanon and argues for the suitability of such programs for war-ravaged economies. It then empirically highlights the role played by the credibility of policy makers in the success or failure of the program and the resulting dynamics of economic variables. The article concludes that the success depends on a political environment that engenders credible policy.

Sticky inflation and the real effects of exchange rate-based stabilization

This paper tests the empirical validity of the forward-looking pricing hypothesis using data from four exchange rate based stabilization (ERBS) episodes. It finds that backward-looking components of inflation play an important role in inflation dynamics, in some cases exceeding the importance of forward-looking components. The paper then shows that the presence of empirically relevant degrees of inflation stickiness increases the size of the real exchange rate appreciation predicted by an imperfect credibility model of ERBS. The 12% real appreciation predicted by the sticky inflation model is a 70% improvement over the predictions of the fully forward looking pricing setup, but as in other ERBS models, still falls short of matching the real appreciations observed in practice.

Political Cycles and Exchange Rate-Based Stabilization

Fixed exchange rates implemented to increase credibility and attract foreign investment, or as an alternative approach to stabilization in high inflation economies, have been shown to be successful in expanding economic activity and correcting inflation in the short term but often lead to undesirable outcomes in the medium to long term. Although there is a wealth of literature documenting the boom-bust cycles associated with the adoption of a nominal anchor, no adequate explanation has been proffered as to governments repeatedly choosing policies that are self-defeating. The authors address this question with a political economy explanation based on the notion of a self-interested government for which short-term stabilization is attractive in the face of incentives posed by the electoral cycle. If the election coincides with the boom phase of an exchange rate—based stabilization, incumbent governments increase the likelihood of gaining reelection, and the bust phase will develop, if at all, only after the contest. The authors thus suggest a modified version of the traditional political business cycle. From the standpoint of a self-interested office-seeking government, exchange rate—based stabilizations can make good political sense. Empirical results based on an analysis of eighteen Latin American countries from 1970 to 1999 support the insights of the argument: movements towards a more fixed exchange rate are greater than three times more likely in a preelection period than in other stages of the electoral cycle.

Sticky Inflation and the Real Effects of Exchange Rate-Based Stabilization

Exchange rate-based inflation stabilization (ERBS) policies are associated with a boom-recession cycle in economic activity and sustained real exchange rate appreciation. A class of models in the literature has explained these empirical regularities with the lack of credibility of the stabilization plans. The lack-of-credibility models typically assume perfectly forward-looking pricing behavior without inflation stickiness and attribute the slow decline in inflation to the consumption boom that occurs due to the perceived temporariness of the ERBS policy. This paper tests the empirical validity of forward-looking pricing behavior in Mexico and Turkey, two countries which have experienced ERBS. It finds that the forward - and backward - looking components of inflation weigh approximately equally in pricing behavior, and therefore, that inflation is partially sticky. The paper then develops the theoretical implications of partial inflation stickiness in a lack of credibility model of ERBS and concludes that the presence of stickiness significantly reduces the persistence of the consumption boom predicted by the model, but helps to explain the recession in the late phase of the stabilization.

Losing Credibility: The Stabilization Blues

In exchange rate-based stabilization programs, credibility often follows a distinct time pattern. At first it rises as the highly visible nominal anchor provides a sense of stability and hopes run high for a permanent solution to the fiscal problems. Later, as the domestic currency appreciates in real terms and the fiscal problems are not fully resolved, the credibility of the program falls, sometimes precipitously. This paper develops a political-economy model that focuses on the evolution of credibility over time and is consistent with the pattern just described. Inflation inertia and costly budget negotiations play a key role in the model.

Capital Markets and the Exchange Rate, with Special Reference to the Dollarization Debate in Latin America

The paper reviews the main challenges faced by policymakers in emerging market economies, EM, in light of recent financial crises, and taking into account salient factors like the existence of partial dollarization, imperfect credibility, weak financial systems, and contagion. The standard theory of optimal currency areas is discussed and criticized for omitting the above factors. When these factors are taken into account, an extreme foreign exchange regime like dollarization is shown to become much more attractive. The paper discusses the pros and cons of dollarization and, among other things, shows that the lack of a lender of last resort is not necessarily a major drawback in EM. The paper also discusses inflation targeting, IT. In a formal model, it is shown that IT could be subject to credibility problems similar to those found in exchange rate-based stabilization programs.

Lending Booms: Latin America and the World

Lending Booms:Latin America and the World Pierre-Olivier Gourinchas (bio), Rodrigo Valdés (bio), and Oscar Landerretche (bio) Lending booms are the cornerstone of numerous recent theories on financial and banking crises.1 The precise origins of lending booms are diverse. They may arise following a possibly poorly regulated financial liberalization, a surge in capital inflow driven by external factors, or a terms-of-trade shock (or other types of supply shock) that boosts domestic investment or consumption or both. They may also come as a consequence of a macroeconomic stabilization program: it has long been noted that exchange rate-based stabilization programs are often associated with ultimately unsustainable booms in consumption, output, and credit. During a lending boom, the typical story goes, credit to the private sector rises quickly. Leverage increases, and financing is extended to projects with low—possibly even negative—net present value, either because monitoring becomes more difficult when the volume of lending increases rapidly, which increases the likelihood of fraud (including looting, self-lending, and evergreening), or because domestic borrowers' net worth increases. As lending expands, the quality of funded projects goes from bad to worse, exposure increases, and the banking sector becomes more vulnerable. Some scholars emphasize the aggravating effect of expected public bailouts in the event of a generalized bankruptcy. Bailout guaranties, whether explicit or implicit, induce private borrowers and lenders to develop [End Page 47] and carry over riskier projects than may be socially efficient. Entrepreneurs and lenders price new projects under the best possible scenario, taking into account the government intervention in the worst states of nature, and the quality of new loans worsens.2 The story usually ends in tears: the private sector gets scared or the projects fail to deliver, the bailout guaranties are called in, and the whole edifice comes tumbling down. Others focus on the importance of the credit channel or financial accelerator.3 The mechanics are relatively straightforward: during a boom, asset prices increase, which increases borrowers' net worth, facilitates new lending, fuels higher asset demand and even higher asset prices, and so on. During the bust, the opposite happens: a proportion of actors are not able to repay their loans, and banks call in the collateral at firesale prices. The banks become more vulnerable as the asset side of their balance sheet shrinks. New loans are curtailed, and investment collapses together with asset prices. As a result of this increased vulnerability, a mild correction in asset prices may trigger a full-blown banking crisis.4 Consumption booms serve as the basis for many other explanations of the boom-bust cycle. For instance, the cycle may stem from an unsustainable consumption boom rooted in a less-than-perfectly-credible exchange rate stabilization program. Calvo and Végh provide an extensive review of these theories.5 There is ample empirical evidence that credit overexpansion and banking crises are related. Demirgüç-Kunt and Detragiache, for instance, show that after controlling for the existence of deposit insurance, the ratio of private credit to gross domestic product (GDP) and the (lagged) real growth of private credit are significant determinants of banking crises.6 Honohan considers credit growth one of the leading variables for diagnosing and predicting banking crises.7 As scholars of the recent financial crises note, countries that rely on foreign capital inflows may experience a nastier variety of financial debacle that combines a banking crisis and a balance-of-payments collapse. Chile [End Page 48] in 1982, Argentina in 1979, Mexico in 1994, and Thailand in 1997 are notorious examples. Several studies examine how the fiscal burden of a banking crisis can generate a balance-of-payments crisis.8 Conversely, a weak financial sector may prevent financial authorities from defending their currency, effectively hastening its demise. Goldfajn and Valdés, as well as Goldstein, study the direct link between an intermediation boom and the likelihood of banking and balance-of-payments crises occurring as a result of capital flows.9 Kaminsky, Lizondo, and Reinhart report that five out of seven studies analyzing credit growth as a determinant of currency crises find statistically significant results.10 In their own currency-crisis warning system, these authors consider that the...

English Title Not Available [Turkish Title: DOVIZ KURUNA DAYALI ISTIKRAR PROGRAMI

This note highlights the crucial elements in an exchange ratehased inflatian stabilization. In theory, such a policy is more efficient compared to the alternatiue money-based one if certain conditions are satisfied. The first condition, indeed a prerequistiue, is the gaining the redibility. Our simulation experiments show that a credible exchange rate fixing would be able to break the intertial Turkish inflatian process. However, we doubt that this aspect has seriously been taken by the practitioners. The movements in various interest rates are an indication of these lacking aspect. We also emphasize that exchange rate-based stabilization is a kind of shock therapy but not a permanent treatment.

Fiscal discipline and the choice of a nominal anchor in stabilization

The conventional wisdom is that exchange rate-based stabilizations induce more fiscal discipline than money-based programs. The Latin American experience does not support this view. Among the major stabilization programs implemented since 1960, the mean increase in the primary balance-to-GDP ratio was 3.2 percentage points under money-based programs, as opposed to only 0.2 percentage points under exchange rate-based programs. We present a model – where fiscal policy is set by an optimizing but non-benevolent government – that replicates this stylized fact. If the policy maker is impatient, a money-based stabilization provides more discipline, and higher welfare for the representative agent, than does an exchange rate-based stabilization.

Exchange Rate-Based Stabilization in Western Europe: Greece, Ireland, Italy and Portugal

This paper compares the experience with exchange-rate–based stabilization (ERBS) of four Western European countries with that of high-inflation developing countries. In general, the behavior of key macroeconomic variables—inflation, output, demand, the real exchange rate and the current account—in the four countries examined did not correspond to the pattern observed in developing countries, although some resemblance to this pattern could be found in Italy in 1987–92 and Greece in 1994–96. The experience with ERBS in Western Europe highlights the importance of incomes policy as an ingredient of a successful stabilization program and shows that the adoption of a looser anchor does not necessarily reduce the output cost of disinflation.

On the Fit of a Neoclassical Monetary Model in High Inflation: Israel 1972- 1990

This paper uses a money-in-tbe-utility model to show that the Israeli data from the high-inflation and poststabilization period fit well the predictions of a simple, neoclassical framework. Specifically, a single parameter money demand equation that is derived from the model fits the data much better than a Cagan money demand ffinction. The model's implsation on the inflation-seigniorage relationship is consistent with the observed fact that while inflation was rising, the inflation-tax revenue remained almost trendless. The labor supply equation derived from the same model is remarkably consistent with the real wage and employment data over the high inflation and stabilization period. There is no evidence for the existence of a Phillips curve employment-inflation trade-off. After the stabilization the demand for money seems to shift. This phenomenon may be due to impxvements in transaction technologies as well as to expecations for stabilization during the high inflation. We also show that temporary fixed exchange rate-based stabilization and consumption boom in the poststabilization period imply low levels of inflation that are consistent with the model.

Exchange rate-based stabilization with endogenous fiscal response

This paper studies the dynamics of inconsistent exchange rate-based stabilization policy —a policy that fixes the exchange rate without an underlying fiscal adjustment to ensure that the exchange rate policy is sustainable in the long run—in a model where the perception that exchange rate policy temporarily leads to an initial expansion in consumption that generates an increase in tax revenues large enough to eliminate the ex-ante fiscal deficit. Therefore an ex-ante inconsistent stabilization program displays, ex-post, all the features of a fiscally consistent one; i.e., a fixed exchange rate and no fiscal deficit. In contrast to the standard results, where the inconsistency between fiscal and exchange rate policy leads to a steady loss of international reserves and culminates in a ‘Krugman type’ balance of payments crisis, this model predicts that along the path towards the balance of payments crisis the economy displays no fiscal deficit and enjoys increasing international reserves.

Exchange rate-based stabilization in Latin America

This paper examines the use of the exchange rate as a nominal anchor for achieving price stability in Latin America. It will explore the impact of exchange rate anchoring on the real sector by analyzing five stabilization programs. The paper will identify conditions that make exchange rate-based stabilization successful and those that lead to its failure. It will also demonstrate that while the income effect can be instrumental in describing consumption booms associated with exchange rate-based stabilizations, the popular view based on the credibility hypothesis fails to explain key events associated with such programs.

Exchange Rate-Based Stabilization in Western Europe: Greece, Ireland, Italy and Portugal

This paper compares the experience with exchange-rate–based stabilization (ERBS) of four Western European countries with that of high-inflation developing countries. In general, the behavior of key macroeconomic variables—inflation, output, demand, the real exchange rate and the current account—in the four countries examined did not correspond to the pattern observed in developing countries, although some resemblance to this pattern could be found in Italy in 1987–92 and Greece in 1994–96. The experience with ERBS in Western Europe highlights the importance of incomes policy as an ingredient of a successful stabilization program and shows that the adoption of a looser anchor does not necessarily reduce the output cost of disinflation.

Exchange Rate-Based Stabilization in Western Europe: Greece, Ireland, Italy and Portugal

This paper compares the experience with exchange-rate-based stabilization (ERBS) of four Western European countries with that of high-inflation developing countries. In general, the behavior of key macroeconomic variablesinflation, output, demand, the real exchange rate and the current accountin the four countries examined did not correspond to the pattern observed in developing countries, although some resemblance to this pattern could be found in Italy in 1987-92 and Greece in 1994-96. The experience with ERBS in Western Europe highlights the importance of incomes policy as an ingredient of a successful stabilization program and shows that the adoption of a looser anchor does not necessarily reduce the output cost of disinflation.

The 1987 Mexican Disinflation Program: An Exchange-Rate-Based Stabilization?

We examine whether Mexico’s disinflation experience during 1987-94 fits a widely accepted set of stylized facts of exchange rate-based stabilization (ERBS), and relate it to theories put forward to account for the boom-recession business cycle associated with ERBS. A cursory look at Mexican data shows that the experience fits quite closely the theoretical predictions and the stylized facts of ERBS. However, the paper shows that there were some important differences and peculiarities of the Mexican case that deserve further study, especially regarding the role of the nominal anchor and the nature of the business cycle.

Credit and Exchange Rate-Based Stabilization

This paper examines the behavior of private sector credit in chronic inflation countries that undergo exchange rate-based inflation stabilizations. It concludes that these programs are characterized by a strong increase in private sector credit, both in absolute terms and as a fraction of real economic activity. Empirical results using data for Mexico, Chile, Argentina, and Israel support a negative statistically significant relationship between credit and inflation for Mexico, Argentina, and Chile, but not for Israel. In addition, for both Chile and Mexico, dummy variables representing periods of inflation stabilization are positive and statistically different from zero indicating a stronger expansion in private sector credit during stabilization. These results could potentially explain the consumption boom that is usually present in the early stages of these programs.