Vegh1992 Details Handout

Stopping High Inflation
Vegh (1992)
Model Details
Javier Garcı́a-Cicco
International Macro
Motivation
Stylized facts for exchange-rate-based plans to stabilize inflation:

I Hyper-inflation episodes (e.g. Convertibility plan):
I Exchange rate adjustment and fiscal reform.
I Inflation is reduced quickly, converging to the new depreciation
rate.
I Relatively low activity costs (i.e. the recession originated by
the hyper-inflation is not exacerbated with the stabilization pro-
gram).
I High Inflation episodes (e.g. Tablita, Austral, etc.):
I Exchange rate adjustment but no fiscal reform.
I Inflation slowly converges to the new depreciation rate.
I Real appreciation; deteriorating CA and TB.
I Initial expansion in activity, followed by a slowdown (even con-
tractions).
I Vegh analyzes the difference between them in terms of credi-
bility.
Javier Garcı́a-Cicco (International Macro ) Stopping High Inflation Vegh (1992) 2/22
General Setup
I Small and open economy, infinite horizon, continous time, no

uncertainty.
I Two goods: tradables (yt∗ , c∗t ) and non-tradables (yt , ct ).
I Law of one price for tradables, and constant world prices: their
price equal the nominal exchange rate Et .
I Free capital mobility (UIP): it = r+εt , where it is the domestic
nominal rate, r is the world nominal rate (assumed constant),
and εt = Ė
Et .
t
∂Xt
I Note: In continuous time Ẋt = . The analogous in discrete
∂t
time is Xt+1 − Xt .
Households
I Period t budget constraint in domestic currency:
Et yt∗ + Pt yt + Et τt + rEt bt = Et c∗t + Pt ct + Et ḃt + Ṁt ,
where: τt are lump-sum transfers from the government (in trad-

able units), bt are net foreign assets, Mt is nominal balances of
domestic currency.
I Dividing by Et ,
yt ct Ṁt
yt∗ + + τt + rbt = c∗t + + ḃt + ,
et et Et
where et = Et /Pt (real exchange rate).
Households
Mt
I Define mt = Et . Deriving with respect to time
˙
Mt Ṁt Et − Mt Ėt Ṁt
ṁt = = 2
= − εt mt .
Et (Et ) Et
I Thus, replacing in the constraint,
yt ct
yt∗ + + τt + rbt = c∗t + + ḃt + ṁt + εt mt ,
et et
I Adding rmt on both sides,
yt ct
yt∗ + + τt + r(bt + mt ) = c∗t + + ḃt + ṁt + εt mt + rmt .
et et
I Using UIP (it = r + εt ),
yt ct
yt∗ + + τt + r(bt + mt ) = c∗t + + it mt + ḃt + ṁt .
et et
Households
I Using the previous expression we can derive the life-time budget

constraint as
Z ∞ Z ∞
yt ct
b0 + m 0 + yt∗ + + τt e−rt dt = c∗t + + it mt e−rt dt.
0 et 0 et
see the appendix for derivation.
I Agents are also subject to a cash-in-advance constraint:
α (Et c∗t + Pt ct ) ≤ Mt .

ct
I The constraint will hold with equality: α c∗t + et = mt .
I Replacing in the life-time constraint,
Z ∞ Z ∞
yt ct
b0 +m0 + yt∗ + + τt e−rt dt = c∗t + (1 + it α) e−rt dt.
0 et 0 et
where (1 + it α) is the “effective price of consumption.”
Households
I Preferences are
Z ∞
[log(c∗t ) + log(ct )] e−rt dt.
0
I The Lagrangian is
Z ∞
[log(c∗t ) + log(ct )] e−rt dt + ...
0
Z ∞
∗ yt ∗ ct −rt
λ b0 + m 0 + yt + + τt − ct + (1 + it α) e dt .
0 et et
I The FOC’s are:
λ
(c∗t )−1 = λ(1 + it α), (ct )−1 = (1 + it α) ⇒ ct = et c∗t .
et
Supply
I The production of tradables is a constant endowment:
yt∗ = y ∗ , far all t.
I The supply of non-tradables is characterized by a Phillips curve:
π̇t = −θ(yt − ȳ).
I This can be derived from a monopolistic firm that is subject to

adjustment costs in setting its price. In other words, prices are
sticky.
Supply
A footnote on the Phillips curve:
I Original Phillips curve, discrete time:
πt = −φ(ut ).
I Expectation augmented Phillips curve:
πt = −φ(ut − un e
t ) + πt+1 .
I Expectation augmented Phillips curve using output gap:
πt = θ(yt − ytn ) + πt+1

e
.
I Without uncertainty, and re-ordering:
πt+1 − πt = −θ(yt − ytn ).
I In continuous time:
π̇t = −θ(yt − ytn ).
I Notice, the price level is pre-determined by the assumption of price sticki-
ness, but inflation can jump.
I What happens if output is temporarily above potential?
Equilibrium
I In the non traded sector yt = ct . Using that ct = et c∗t ,
π̇t = −θ(et c∗t − ȳ)
I Fiscal policy is assumed to use the transfer to give households

the newly printed money: Et τt = Ṁt . This can be written as
Z ∞ Z ∞
m0 + (τt ) e−rt dt = (it mt ) e−rt dt.
0 0
I Combining this and the equilibrium in non-tradables in the life-

tiem constraint, we obtain the sustainability of the current ac-
count: Z ∞ Z ∞
b0 + (yt∗ ) e−rt dt = (c∗t ) e−rt dt
0 0
I Given that yt∗ = y ∗
∞
y∗
Z
b0 + = (c∗t ) e−rt dt
r 0
Equilibrium
I The UIP is also an equilibrium condition:
it = r + εt
Et
I From et = Pt
ėt
= εt − πt
et
I Finally, we also have the FOC:
(c∗t )−1 = λ(1 + it α)
I These are 5 equations for six unknowns: πt , et , c∗t , it , t , λ. We

also need to specify monetary policy.
Equilibrium with crawling peg
I Suppose εt = ε for all t.

I From UIP we have it = i = r + ε = i for all t.
I Given that it is constant, we have that c∗t = c∗ = [λ(1 + iα)]−1
also constant.
I Using the BOP condition we can derive c∗ = b0 r + y ∗ .
I We are left with two differential equations for two variables:
π̇t = −θ(et c∗ − ȳ)
ėt
= ε − πt
et
I Steady state: equilibrium such that variables do not change. In
this case ėt = π̇t = 0, so that πt = ε and et = cȳ∗ .
I The equilibrium is saddle-path stable around this steady state.
Equilibrium with crawling peg
Phase Diagram
ėt
π̇t = −θ(et c∗ − ȳ), e t = ε − πt .
C
B
A .
e=0
e0 ess e
Credible Stabilization Plan
I Suppose the economy was in a steady-state equilibrium with

εt = εH . In such a case πt = εH and et = cȳ∗ .
I At time 0, a permanent reduction in the devaluation rate is
announced: εt = εL < εH for t > 0, but the nominal exchange
rate at the time of the announcement is determined by the old
rule. In addition, assume people believes the whole announce-
ment.
I From UIP, the nominal interest rate falls it = iL = r + εL for
all t.
I However, as this rate is still constant, then the equation c∗t =
[λ(1 + iL α)]−1 implies that c∗t is still constant.
I But whenever c∗t is constant, the BOP condition implies c∗ =
b0 r + y ∗ . So the change in policy does not change the steady
state value of c∗ .
I Therefore the new steady state is characterized πt = εL and

et = cȳ∗ .
I Moreover, given that e = E/P and both are predetermined (E
was determined by the previous rule and P is pre-determined
due to price-stickiness), e cannot jump.
I Thus, the system must jump to the new equilibrium instanta-
neously.
I Finally, given that c∗ and e do not change, c remains at its
steady state level also. So the new policy lowers inflation with-
out generating any output cost.
I These facts are consistent with the successful stabilization plans
that were used to stop hyper-inflations.
Phase Diagram
C
B
A .
e=0
ess e0 e
Non-Credible Stabilization Plan
I Again we start from a steady-state equilibrium with εt = εH .

In such a case πt = εH and et = cȳ∗ .
I At time 0, permanent reduction in the devaluation rate is an-
nounced: εt = εL < εH for t ≥ 0, but the nominal exchange
rate at the time of the announcement is determined by the old
rule. However, people acts assuming that this new policy will
last only for 0 ≤ t < T , and afterwards εt = εH for t ≥ T .
I From UIP, the nominal interest rate will be it = iL = r + εL
for 0 ≤ t < T and then it = iH = r + εH for t ≥ T .
I This generates an inter-temporal trade-off for consumption, as

the “effective price” is lower during 0 ≤ t < T . Thus, c∗ will
rise for 0 ≤ t < T and then fall.
I In turn, this produces a current account deficit during the tran-
sition, that increases over time due to the increase in debt.
I Graphically:
a. Rate of devaluation b. Consumption of tradable goods
T
c
rk 0 + yT
0 T Time 0 T Time
I In terms of non-traded inflation, there are two forces that play

a role. First, from eėtt = εt − πt , if the RER does no change this
should tend to lower π.
I At the same time, ct = et c∗t implies that, as c∗t rise, ct will tend
to rise and et to lower. And the effect is not only in prices (i.e.
not just in et ) because prices are sticky.
I Both these effect tend to rise π.
I On impact, the first effect dominates because the e is predeter-
mined. But after some time the second effect will play a larger
role. In addition, after tome T inflation must return to εH .
I In addition, because inflation does not fall as much as the nom-
inal depreciation, the RER will appreciate over time.
Graphically:
c. Inflation rate of nontradables d. Real exchange rate
0 T Time 0 T Time
I Finally, because the RER appreciation is gradual, the consump-

tion of non tradables (and its production) will rise in the tran-
sition. So the plan generates an expansion in the short run.
I Graphically,
e. Consumption of nontradable goods f. Domestic real interest rate
cN rd
r
yfN
0 T Time 0 T Time
I All these effects are consistent with the several stabilization

plans that were used to try to stop chronic-inflation episodes,
as documented by Vegh (1992).
Appendix: Life-time constraint
I Start from
yt ct
yt∗ + + τt + r(bt + mt ) = c∗t + + it mt + ḃt + ṁt .
et et
I Let xt = yt∗ + yt ct
et
+ τt − (c∗t + et
+ it mt ) and at = bt + mt .
I Multiplying both size by e −rt
, re-arranging, and integrating from 0 to a
given period T , we obtain
Z T Z T
(ȧt − rat ) e−rt dt = (xt ) e−rt dt.
0 0
I The left hand side can be written as

T
dat e−rt
Z
dt = aT e−rT − a0
0 dt
I If T → ∞, limT →∞ aT e−rT = 0 by the transversality condition.
I Thus, we can write,
Z ∞ Z ∞
yt ct
b0 + m 0 + yt∗ + + τt e−rt dt = c∗t + + it mt e−rt dt.
0 et 0 et

Vegh1992 Details Handout

Uploaded by

Copyright:

Available Formats

Vegh1992 Details Handout

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Vegh1992 Details Handout

Uploaded by

Copyright:

Available Formats

Stopping High Inflation

Stylized facts for exchange-rate-based plans to stabilize inflation:

I Small and open economy, infinite horizon, continous time, no

I Period t budget constraint in domestic currency:

Et yt∗ + Pt yt + Et τt + rEt bt = Et c∗t + Pt ct + Et ḃt + Ṁt ,

where: τt are lump-sum transfers from the government (in trad-

I Using the previous expression we can derive the life-time budget

where (1 + it α) is the “effective price of consumption.”

I The production of tradables is a constant endowment:

yt∗ = y ∗ , far all t.

I The supply of non-tradables is characterized by a Phillips curve:

π̇t = −θ(yt − ȳ).

I This can be derived from a monopolistic firm that is subject to

I Expectation augmented Phillips curve:

I Expectation augmented Phillips curve using output gap:

πt = θ(yt − ytn ) + πt+1

I Without uncertainty, and re-ordering:

πt+1 − πt = −θ(yt − ytn ).

I In the non traded sector yt = ct . Using that ct = et c∗t ,

π̇t = −θ(et c∗t − ȳ)

I Fiscal policy is assumed to use the transfer to give households

I Combining this and the equilibrium in non-tradables in the life-

I The UIP is also an equilibrium condition:

(c∗t )−1 = λ(1 + it α)

I These are 5 equations for six unknowns: πt , et , c∗t , it , t , λ. We

I Suppose εt = ε for all t.

π̇t = −θ(et c∗ − ȳ)

I Suppose the economy was in a steady-state equilibrium with

I Therefore the new steady state is characterized πt = εL and

I Again we start from a steady-state equilibrium with εt = εH .

I This generates an inter-temporal trade-off for consumption, as

I In terms of non-traded inflation, there are two forces that play

c. Inflation rate of nontradables d. Real exchange rate

I Finally, because the RER appreciation is gradual, the consump-

I All these effects are consistent with the several stabilization

I The left hand side can be written as

You might also like

I These are 5 equations for six unknowns: πt , et , c∗t , it , t , λ. We