Disinflation Dynamics in an Open Economy General Equilibrium Model

This paper studies money based and exchange rate based disinflation in an open economy model with explicit microfoundations. For benchmark parameter values, it is found that a money slowdown leads to a recession in the short run whereas exchange rate based disinflation leads to very rapid adjustment with minimal real effects. This corresponds to the results of directly postulated models. Overshooting of the exchange rate in response to a money slowdown, however, only occurs when there is pricing-to-market behavior. It is found that by varying certain key parameter values such as the intertemporal rate of discount and the degree of price inertia, exchange rate based stabilization can produce substantial real effects. This contrasts with the results of directly postulated models and is related to issues highlighted by the introduction of microfoundations.