Chapter 24 Inflation stabilization and bop crises in developing countries

High and persistent inflation has been one of the distinguishing macroeconomic characteristics of many developing countries since the end of World War II. Countries afflicted by chronic inflation, however, have not taken their fate lightly and have engaged in repeated stabilization attempts. More often than not, stabilization plans have failed. The end of stabilizations — particularly those which rely on a pegged exchange rate — has often involved dramatic balance-of-payments crises. As stabilization plans come and go, a large literature has developed trying to document the main empirical regularities and to understand the key issues involved. This chapter undertakes a critical review and evaluation of the literature related to inflation stabilization policies and balance-of-payments crises in developing countries. The chapter begins by trying to rationalize the existence of chronic inflation in a world of rational agents. It then offers an empirical analysis of the main stylized facts associated with stopping chronic inflation. It is shown that the real effects of disinflation depend on the nominal anchor which is used. Exchange-rate-based stabilizations lead to an initial output and consumption boom — which is particularly evident in the behavior of durable goods — real exchange rate appreciation, and current account deficits. The contractionary costs typically associated with disinflation emerge only later in the program. In contrast, in money-based stabilizations, the contraction occurs in the beginning of the program. The chapter then proceeds to review several explanations for these puzzling phenomena, emphasizing the real effects of lack of credibility, inflation inertia, and consumption cycles generated by durable goods purchases. The chapter also documents the fact that most exchange-rate-based stabilizations end up in balance-of-payments crises. The Mexican crisis of December 1994 brought back to life some of the key questions: Do exchange-rate-based stabilizations sow the seeds of their own destruction by unleashing “unsustainable” real exchange rate appreciations and current account deficits? Or are credibility problems and self-fulfilling prophecies at the root of these crises? The remainder of the chapter is devoted to analyzing the main ideas behind this unfolding literature.